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Navigating the roadmap for portfolios in 2022

Identifying investment opportunities and potential headwinds

The weariness of ongoing pandemic pressures may be casting a bit of a shadow on what’s typically an exciting start to a new year. But there remains a strong sense of optimism that this health crisis will soon come to an end.

Hopeful optimism may also be a good way to consider current economic conditions and what that means for growth, stock valuations, opportunities in equities, cautious recommendations for fixed income, and the impact of inflation.

Manulife Investment Management’s Capital Markets Strategy Co-Chief Investment Strategists, Kevin Headland and Macan Nia, offer a few insights for the months ahead.


Stability 

  • Consumer spending continues to be strong, corporate balance sheets are in good shape, and there are many indicators for a positive growth environment again this year — albeit, not quite the same level of growth as 2021.

 

  • Have we peaked in terms of growth? Yes, but not being at the peak doesn’t mean weakness.

 

  • A solid economic environment both in the U.S. and globally is likely here to stay for much of 2022. There may be bumps in the road, such as the unpredictable pandemic, but growth continues to trend in the right direction.

 

  • Looking at the economic forecasts for several countries, many are indicating a high degree of confidence that their production rates will be higher by the final months of 2022. Headwinds related to supply chain issues are expected but those backlogs are also expected to diminish by the second half of 2022.

Leading economic indicators have peaked but remain above pre-covid levels.

At the current level and historical pace in which it takes the LEI to trend toward zero during the mid-cycle, it would suggest that the U.S. economy is in a stable position going into 2022. Excluding the recent ‘self-induced’ recession caused by the pandemic, since 1970, a recession and market peak occurred six months, on average, after the LEI became negative.

Conference Board's Composite Index of Leading Economic Indicators

1970 -  Current

Leading economic indicators have peaked but remain above pre-covid levels.  At the current level and historical pace in which it takes the LEI to trend toward zero during the mid-cycle, it would suggest that the U.S. economy is in a stable position going into 2022. Excluding the recent ‘self-induced’ recession caused by the pandemic, since 1970, a recession and market peak occurred six months, on average, after the LEI became negative.  Conference Board's Composite Index of Leading Economic Indicators

Source: Capital Markets Strategy, Bloomberg. As of November 30, 2021

Inflation

  • In 2021, we’d expected the inflationary environment to be more enduring, rather than transitory, which appears to be the correct call based on very conservative inflationary inputs. Inflation is running higher and longer than expected. We feel it’s higher than it should be and we expect to see a decrease. Our current inflation model predicts inflation to remain above 3.5 per cent for the first half of 2022 and continuing above three per cent for the rest of the year. While it’s unlikely to fall back to the pre-pandemic two per cent level this year, it’s also unlikely to remain at the elevated six per cent level.[1]
  • When asked why inflation is expected to remain elevated above the more familiar two per cent level, we think it really comes down to wages and food prices. Increasing minimum wages, supply chain issues, and weather-related food production complications all contribute to the inflation story. Growth rates are slowing for things such as oil prices, which should have a moderating factor for inflation, but not in a dramatic fashion.

Inflation should moderate but remain above pre-pandemic levels

Our inflation model suggests CPI will trend lower from current levels of 6.8 percent but will likely stay above 3 percent through the third quarter of 2022.  It is unlikely to fall to levels prior to the pandemic as wage and food inflation will likely remain persistent.  Inflation will remain a concern throughout 2022 but receive nowhere near the level of attention it is receiving today. 

CPI YOY vs CMS Inflation Model

1998 - November 2022 (Including Forecast)

Inflation will moderate but remain above pre-pandemic levels  Our inflation model suggests CPI will trend lower from current levels of 6.8 percent but will likely stay above 3 percent through the third quarter of 2022.  It is unlikely to fall to levels prior to the pandemic as wage and food inflation will likely remain persistent.  Inflation will remain a concern throughout 2022 but receive nowhere near the level of attention it is receiving today.   CPI YOY vs CMS Inflation Model

Source:  Capital Markets Strategy, Bloomberg. As of November 30, 2021

Equities

  • Normalization may best describe equities for 2022. We’ve moved from a brief recession through a V-shaped recovery, and now we’re in the normalization phase of the economic recovery. For earnings growth, this means a more normal rate of return versus the fast trajectory that we’ve witnessed over the past 18 months. We’re still optimistic for solid earnings growth, with pent-up demand continuing among consumers, creating room for companies to grow their earnings.

 

  • There’s also likely to be more focus on quality earnings in 2022. This refers to companies that can maintain resilient stock prices regardless of the economic cycle and are able to expand regardless of what inflation is doing.

 

  • Manufacturing tends to be a good predictor of earnings and our proprietary manufacturing Nuts and Bolts Index, which analyzes a range of manufacturing across the U.S., is showing solid data. We predict earnings growth of around 18 per cent this year, which supports our opinion that returns for equities will remain solid and consistent for 2022.

Earnings growth looks to be on a solid footing in 2022

The historical relationship between year-over-year (YOY) earnings growth, our proprietary manufacturing index (Nuts & Bolts Index), and South Korean exports would suggest a weaker but still solid earnings environment through at minimum the first half of 2022. A continuation of the current fundamental backdrop should be supportive of earnings growth strong on a YOY basis through 2022.

Nuts & Bolts Index vs. S&P 500 Trailing 12 Month Earnings Growth

2000 - current 

Earnings growth looks to be on a solid footing in 2022  The historical relationship between year-over-year (YOY) earnings growth, our proprietary manufacturing index (Nuts & Bolts Index), and South Korean exports would suggest a weaker but still solid earnings environment through at minimum the first half of 2022. A continuation of the current fundamental backdrop should be supportive of earnings growth strong on a YOY basis through 2022.  Nuts & Bolts Index vs. S&P 500 Trailing 12 Month Earnings Growth

Source:  Capital Markets Strategy, Bloomberg. As of November 30, 2021

  • When examining U.S. equity data, we expect only moderate headwinds this year, along with stable earnings growth. We think there’s a will to move the markets higher, and any volatility appears to be short-lived, with a down day quickly followed by upward momentum as investors buy the dip.

Valuation will be less of a headwind in 2022

During periods when earnings growth is between 10% and 20% on a year-over-year basis (as we believe it will be in 2022), the average PE contraction is 1 multiple point.  When earning growth is between 10% and 20% YOY, the average 12-month returns for the S&P 500 Index is 8.9%. This helps us frame our expectations for returns in the upper single digit/low double digit returns with risk to the upside for the S&P 500 index in 2022.

Year-over-Year Change in S&P 500 Index Earnings per Share vs Change in Trailing PE Multiple Last 50 years

Valuation will be less of a headwind in 2022  During periods when earnings growth is between 10% and 20% on a year-over-year basis (as we believe it will be in 2022), the average PE contraction is 1 multiple point.  When earning growth is between 10% and 20% YOY, the average 12-month returns for the S&P 500 Index is 8.9%. This helps us frame our expectations for returns in the upper single digit/low double digit returns with risk to the upside for the S&P 500 index in 2022.  Year-over-Year Change in S&P 500 Index Earnings per Share vs Change in Trailing PE Multiple Last 50 years

Source:  Capital Markets Strategy, Bloomberg. As of November 30, 2021


  • For Canadian earnings, the S&P/TSX Composite Index is strongly tied to oil. Oil prices in early 2021 created a lot of excitement, which, in turn, supported strong stock returns. As part of our consensus on normalization, we don’t expect any dramatic moves up for oil prices this year, but we do expect stable, consistent pricing in the range of $80/barrel. This, in turn, could provide a stable platform for Canadian stocks.

The backdrop for the S&P/TSX will not be as positive in 2022

Historically, earnings growth for the S&P/TSX has correlated with the change in the price of WTI YOY. Using US$80/bbl as a likely average target price, we expect S&P/TSX earnings to come down from recent elevated levels but remain attractive through the first half of 2022. 

Change in Oil Price (YOY) vs Change in S&P/TSX Earnings per Share Lagged 3 Months (YOY)

1996 - May 2022 (Estimated)

The backdrop for the S&P/TSX will not be as positive in 2022  Historically, earnings growth for the S&P/TSX has correlated with the change in the price of WTI YOY. Using US$80/bbl as a likely average target price, we expect S&P/TSX earnings to come down from recent elevated levels but remain attractive through the first half of 2022.   Change in Oil Price (YOY) vs Change in S&P/TSX Earnings per Share Lagged 3 Months (YOY)

Source:  Capital Markets Strategy, Markit. As of November 30, 2021

Fixed income

  • It’s very rare to see two consecutive years of negative returns in fixed income, but expectations should still be tempered for 2022. The return potential within the corporate credit space isn’t as strong as previous years, and when you look at credit trends going back to 1996, current rates indicate there’s little room for opportunity.

Credit spreads are near all time tights.

When it comes to credit, we look at the spread as a good indicator for whether we are getting appropriately compensated for the additional risk.  The 20-year median spreads for ICE BofA US High Yield Index and the ICE BofA US Corporate Index are 477 and 138 basis points, and currently, they are 361 and 102 basis points, respectively. This puts them around the twenty-fifth percentile over their history. We believe that, although there is little probability of material downside in credit, that current credit spreads don’t leave much room for upside.

Credit spreads are near all time tights.  When it comes to credit, we look at the spread as a good indicator for whether we are getting appropriately compensated for the additional risk.  The 20-year median spreads for ICE BofA US High Yield Index and the ICE BofA US Corporate Index are 477 and 138 basis points, and currently, they are 361 and 102 basis points, respectively. This puts them around the twenty-fifth percentile over their history. We believe that, although there is little probability of material downside in credit, that current credit spreads don’t leave much room for upside.

Source:  Capital Markets Strategy, Bloomberg. As of November 30, 2021


  • There are opportunities within the high-yield space, but expectations should be tempered for fixed-income upside in 2022. It’s important to have a flexible mindset and be in the right areas of high yield without taking on too much risk.

 

  • Considering an umbrella approach to your fixed-income holdings can also help to protect against any potential economic headwinds. In this current normalization phase, we believe it’s important to maintain a portion of your portfolio in bonds, which can offer stability and protection during times of volatility. Adjusting a portion of your fixed income from high yield to lower risk offers the opportunity for a cash-on-the-side strategy in case of buying opportunities in equities.

While there are many positive signals for solid economic growth this year, there are potential pitfalls, which could include economic policy missteps, continued pandemic headwinds, the impact of inflation on consumer spending, geopolitical pressures, and then the unknown or unforeseen circumstances that can toss a wrench into the mix.

As always, it’s important to be prepared for the unexpected by having a diversified portfolio along with realistic expectations for market growth.

For more investment insights, bookmark the Investments Unplugged podcast or visit the Investments section of Advisor Focus magazine.




[1] The above forecast is based on estimate and analysis made. There is no guarantee the estimate will be achieved.



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