As the Wave of Liquidity Finally Goes Out…Real Outperformers May be About to Shine

12.22.2021 - Carin L. Pai, Head of Portfolio Management

Too Much of a Good Thing?
Since the Federal Reserve began its quantitative easing program to increase liquidity in the economy and the US government pushed through several stimulus packages to fight off a prolonged recession from the COVID crisis, the US equity markets have staged an impressive run, with an 18% return in 2020 followed by a 21% return in 2021.1

This means that the 10-year cumulative return for the S&P 500 has been a whopping 350%.2 Such performance brings to mind Warren Buffet’s quote that “it’s only when the tide goes out that you learn who has been swimming naked."

This exceptional performance has led many investors to question the valuations of equities. Indeed, price levels have expanded handsomely since the lows seen in March 2020, for an impressive 102% gain.3 The valuation of equities currently stands at a relatively high point by many measures including the price to earnings (P/E) ratio at 21x (which is higher than the historical average of 16x) and the Case-Shiller cyclically adjusted P/E ratio of 38x, compared to the historical average is 27x.4 The only valuation that argues equities are reasonably priced is the slightly obscure equity risk premium.5 It currently stands at 3.4%, implying that equities still offer excess return over bond yields, given that the 10-Year US Treasury yield was recently 1.4% and investors are likely compensated to take risk in equities.This is the reason why it is so important to know where interest rates and bond yields are headed. If bond yields move higher, the excess earnings yield on equities will undoubtedly be lower.

No Multiple Expansion in 2022, but Profit Growth Should Continue
Given the relatively high valuations, we do not expect to see equity values to rise substantially next year. Instead, we anticipate market gains will come from profit growth, which has accounted for the entire S&P 500 return for 2021 (Chart 1). We expect that same growth to continue to drive gains in 2022. S&P 500 EPS, shown in Chart 2, will likely increase 8% as the economy expands, albeit down from the high growth rate witnessed in 2021, when profits grew over 40%.   

Chart 1: Earnings continue to grow and could drive equity gains
Earnings and valuations percent change in S&P 500 Year-to-date, indexed to 100 (%)

Chart 2: Earnings Expected to Rise Next Year
S&P 500 bottom-up earnings per share (EPS) estimates

Source: Calendar year EPS actuals & estimates. FactSet, Bloomberg, Data as of 11/30/2021. Important data provider notices and terms available at
Profit margins should rise despite ongoing input cost pressures such as rising labor costs, materials and transportation costs, along with energy costs, given the well-documented supply chain challenges. We expect some pricing power and productivity gains to be retained by manufacturers in the new year.

Moreover, we anticipate equity valuations may contract given the heightened prospects of the Fed reducing its emergency bond buying program and raising interest rates. Interest rates tend to be negatively correlated with valuations on equities as shown in in the chart above. With yields increasing, government support programs drying up and earnings growth slowing, the risk/reward for the S&P 500 looks less attractive at current prices. However, strong GDP growth should continue to support equities and provide investment opportunities at the stock level for active managers.  

Chart 3: P/E Ratios Typically Decrease As Yields Increase
Price-to-earnings (2011 to 2022)

Source: FactSet as of 11/30/2021. Important data provider notices and terms available at
The key risk to our positive outlook on equities is inflation remaining stubbornly high, which would present pressure on the Federal Reserve to be more aggressive in reigning in liquidity. We expect supply chain constraints to slowly ease in 2022, but labor costs will be a bigger challenge to contain.

Clearly, we face an unusual economic landscape. But there are still several ways to approach investing today.

How to Invest in an Inflationary Environment

1. Seek out companies with pricing power. Pricing power, the ability of a firm to raise prices, and strong market positioning will likely be key to maintaining or expanding margins. Companies possessing either characteristic could be rewarded with higher EPS ratios. Innovation tends to drive pricing power, so companies which focus on reinvesting in their businesses and embracing new technologies to create products or differentiated services can command higher prices. Consumer brands with digital distribution and omni-channel experience should help their companies maintain pricing power, as convenience is a desirable and valuable attribute for which consumers seem willing to pay a premium.

2. Look for firms with effective cost management featuring economies of scale. We avoid companies with high-cost structures and high labor costs, which can eat into operating margins. We expect wage increases to continue to pressure some companies. Firms with diverse sourcing of input materials, manufacturing facilities, or scale to negotiate and manage transportation costs will be better able to manage supply chain disruptions. Companies will also need to be creative in navigating the shift to an increasingly remote workplace. Compensation packages may need to be re-thought to attract and retain talent in a more competitive and dynamic job market.

3. Consider equities that experience rising investments in their businesses. Capital expenditures (capex) should be strong in 2022. The robust capex cycle in the current recovery supports our generally bullish outlook. Globally, fixed investment in businesses has recovered faster than GDP and also quicker than in recent downturns. In the US, the recovery in corporate investment spending is the fastest of any cycle since the 1940s.9

Recoveries driven by investment spending can be durable, and if new capital investment embodies greater technological advancement, productivity could be boosted as well, further lessening inflationary pressures and allowing strong growth to continue.

Technology companies stand to benefit as their customers look to gain productivity and reduce dependence on labor. Many software, cloud-based service and data security companies may benefit from the continued shift towards everything digital. Industrial firms which are exposed to infrastructure spending on electrical grids, renewal energy and construction, should also be beneficiaries.

A Parting Thought on Sectors and Style Preferences in 2022 for Equities
We enter the new year favoring earnings stability and reasonable valuation, given our view for a tougher operating environment and higher short- and long-term interest rates. In this more challenging environment, companies which have been lifted by a rising tide of liquidity, may falter as the tide goes out, and we will see who’s been swimming with and without any clothes on. While our primary theme for 2022 is to focus more on specific high-quality stocks rather than sectors and styles, they can’t be ignored all together. Hence, our actively managed equity strategy is overweight healthcare, technology and communications but more positive on business services and reasonably priced software firms. With our view for a reduction in demand from this year's overconsumption, we have underweighted consumer discretionary (particularly goods-oriented companies, which compromise most of the sector) and tech hardware.

In the very near term, we favor large over small caps and have a slight preference for value over growth but expect that growth will outperform longer term as macroeconomic uncertainty increases with more constrained financial conditions.

(1) Source: Bloomberg, as of 11/30/2021. Returns for 2021 are year-to-date through 11/30(2) Source: Bloomberg, as of 11/30/2021. Returns for 2021 are year-to-date through 11/30(3) Source: Bloomberg, as of 11/30/2021(4) Source: Bloomberg, as of 11/30/2021(5) The Equity Risk Premium is the earnings yield of the S&P Index vs the 10 Year US Treasury bond yield(6) Source: Bloomberg, as of 11/30/2021(7) Profit margin is the amount by which revenue from sales exceeds costs in a business. (8) Source: Bloomberg, as of 11/30/2021 (9) Source: Bloomberg, as of 11/30/2021

This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.


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