As we head into the third week of 2022, there has been a significant amount of market volatility for a number of factors. Inflation is at an all time high, the Fed interest rate hikes are looming (seemingly having a disproportionate effect on technology stocks), and there is still a vast uncertainty surrounding COVID.
What are some of the major risks that the market faces in 2022?
Economic Growth - Neutral Risk
Economic growth and others around the world likely peaked in the summer of 2021. However, they continue to grow at a good pace, but short-term risks remain including supply chain disruptions and new COVID variants. It is a market environmental akin to “two steps forward, one step back”. Healthy savings rates, strong corporate balance sheets and a solid jobs market continue to support economic growth.
Valuation - Potential Risk to the Downside
Earnings recoveries tend to see P/E contraction. Trailing S&P 500 Index 12M P/E ratio falls 1‒2 points through to the end of 2022 on rising earnings and above average inflation. The order is important as an earnings recovery supports an orderly valuation contraction while higher inflation results in greater market volatility.
Earnings - Potential Risk to the Upside
Earnings growth peaked in Q2 2021. S&P 500 Index earnings expected to continue to grow though 2022 at a pace in the mid-teens. The reasoning for this outlook is explained a little further down in this blog.
Yield Curve - Steepen
The U.S. Federal Reserve and Bank of Canada will end their asset purchases in 2022. The short end of the yield curve will start to price in increases in overnight rates. The longer end of the curve continues to increase as inflation remains above 2.5%. The market could likely be overly aggressive in its expectation for the number of rate hikes.
Credit - Neutral Risk
Credit spreads remain well below average but can tighten a bit further. Returns are predominantly yield-driven as bonds come under pressure from a rising yield environment. Security selection is key as broad market yields are not compensating for relative risk.
Oil Prices - Risk to the Upside
Oil prices trend marginally higher as inventories and production remain low, demand continues to improve, and the US dollar weakens marginally. West Texas Intermediate trends between US$80-85/bbl over the next 12 months.
Currency (CADUSD) - Risk to the Upside
The Canadian dollar faces upside pressure from oil prices and 2-year yield differential. The market continues to price in a more hawkish Bank of Canada than the Fed and stronger oil. CADUSD trends higher with a target range of US$0.81-83 over the next 12 months with risk to the upside.
2022 Equities Market Outlook
Global Economic Activity Remains Strong Despite Peaking in Mid 2021
Economic activity likely peaked in the summer of 2021 and will face headwinds due to supply chain challenges over the coming months but overall, the global manufacturing environment remains in a resilient position. A PMI reading over 50 or 50% indicates growth or expansion of the manufacturing sector as compared to the previous month, while a reading under 50 suggests contraction.
Inflation Will Moderate but Still Remain Above Pre-Pandemic Levels
Manulife Investment Managements 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.
Earnings Growth Looks to Have a Solid Footing in 2022
The historical relationship between year-over-year (YOY) earnings growth, MIM's 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 year-over-year basis through 2022.
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 earnings 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.
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 Crude Oil year-over-year. 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.
All in all, while we may not approach the same level of economic growth that we saw in the first half of 2021, the market is positioned strongly for upper single digit to lower double digit numbers in 2022 as it stands right now. This is not to say, however, that there will not be bumps along the way. If the last 2 years has taught any of us anything, it's that the unexpected will likely occur, but we are capable of overcoming it.
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