The 10-year U.S. Treasury yield sits below 1.60%, even with inflation running at 6.2%. The CEO of a trillion-dollar S&P 500 company just erased a fifth of its value by asking the “Twittersphere” if he should sell a chunk of his stake. “Meme” stocks continue to trade at levels that appear completely disconnected from fundamental reality. Investors might well conclude that markets are about to head off the rails.
Unfortunately, these are but a few examples of the frothiness in parts of the market today. We have short-lived manias driving bubble-like valuations. We have white-hot economic data rubbing up against loose monetary and fiscal policies. We have dysfunctional supply chains and renewed Cold War-like geopolitics.
In light of this, how should one think about positioning equity portfolios for 2022?
Taking a step back from it all, we think there are a couple of simple equity market investment themes that cut through the noise and uncertainty. As we outlined in our Solving for 2022 publication, these themes involve seeking out value when valuations are stretched, and seeking out real income when inflation is high and real rates are low.
One of our key macro themes for next year is that inflation, while easing from its current rate, is likely to persist at higher levels than we have become used to. Supply-chain bottlenecks and labor market imbalances could also make it more problematic for central banks to manage. Some of our other themes, such as the growing politicization of the global economy and the transition to net-zero emissions, are likely to feed into this inflationary outlook.
That means we anticipate rising bond yields, which, all other things being equal, would put pressure on equity valuation multiples. And that is an important reason why we think value equities can continue the comeback they started this year.
Value can help mitigate this potential downside in multiples in two ways. First, the average value stock has a multiple lower than the market’s. This usually reflects investor assumptions of an extended period of depressed profitability for these stocks. But that tends to make value stocks positively geared to economic strength: Improving profitability, driven by a stronger economy, often leads to them being rerated and outperforming the market. Second, because value stocks’ projected earnings and cash flows are weighted closer in time than those of growth stocks (often referred to as “equity duration”), their valuations tend to exhibit less sensitivity to rising yields.
We would also consider attractively priced regions, such as Europe and Japan. These economies are more cyclical, and thus more “value-like,” and their equity markets have underperformed the U.S. for many years. These export-led, cyclical companies are well positioned to benefit from global reflationary dynamics.
Our second equity theme is income. We view equity income investing as a subset of value investing: Financials and utilities are two sectors where the factors overlap and, in terms of performance, income has lagged growth even more than value over the past decade.
Why do we think equity income is attractive now?
As with value stocks, that decade of underperformance now gives steady dividend payers a valuation buffer against a market correction. But in this case, the dividends themselves add to that buffer: In our view, over the coming months dividends are more likely to be maintained than multiples, which we regard as stretched.
In addition, dividend growth has historically tended to be highly correlated with, but faster than, the inflation rate. That is one reason why equity income has lagged so much over the past decade, while inflation has been low. We therefore believe there could be a lot of catch-up dividend growth to come—especially if we are seeing a reversal of the past 30 or 40 years of low inflation and declining rates.
Right now, much of the global economy is running at a robust pace. But that is accompanied by higher and more problematic inflation than we have experienced for decades. While it is certainly not our main scenario, that has introduced the risk of a monetary or fiscal policy error. Either way, we think 2022 could be a momentous time, as years of low rates, low inflation and enormous monetary support start to change.
In our view, value and income can offer equity investors a buffer against these risks, while still offering an attractive opportunity if, as we anticipate, the reflationary expansion remains on track.