Open with markets in motion page
Welcome to RBC’s Markets in Motion podcast, recorded January 18th, 2022. I’m Lori Calvasina, Head of US equity strategy at RBC Capital Markets. We’ve just published our big monthly chart book digging into the US equity market from top to bottom, looking at everything from the S&P 500 to style to sectors to industries to factors and Small Caps.
Two big things you need to know. First, we’re sticking with our 5,050 forecast for the S&P 500 at year end 2022, a tougher year but one that ultimately sees modest gains. Second, while we still like Value and Cyclicals in early 2022, we’ve lost faith in Small Caps ability to see an early year outperformance trade and dig into the reasons why.
If you’d like to hear more, here’s another five minutes. While you’re waiting, a quick reminder that you can subscribe to this podcast on Apple, Spotify, and other major podcast platforms. Now, the details.
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- Takeaway #1: There’s no change to our market call - we are sticking with our 5,050 forecast for the S&P 500 in 2022.
- Overall, we think 2022 will be a year of modest gains of about 6%. US equities have been caught between the tailwinds of a strong economy and the headwinds of more hawkish monetary policy in early 2022, and we think that this tug of war will set the tone for the year.
- We’ve refreshed the different models we use to arrive at our target and have added few new ones. In total, we’re looking at 14 different inputs.
- 5,050 remains in line with the average of all of them. Admittedly, they point to a wide range of outcomes (the most bearish is ~4,400, the most bullish is ~5,600).
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- We think our economic modeling captures the bull case best, with four of our five economic based tests pointing to an S&P 500 that ends the year ~5,200. These models bake in the idea that real GDP will come in around 3.9% in 2022 and 2.5%, the consensus among sell-side economists (which we think is what ultimately drives market behavior, those numbers are also in line with our own in house economist).
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- On the flip side, we think that two of our valuation approaches, which examine how much lower multiple contraction could take the stock market down this year, do the best job of articulating the bear case. These bake in 10-15% multiple contraction, depending on the multiple used, which is the typical downside in tightening cycles. These tests suggest that the S&P 500 could end the year in the 4,400-4,600 area.
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- A new input that we’ve added also attempts to bake in the impact of quantitative tightening. There, we only have one example to look at – 2018 when stocks fell more than 6% for the full year. A repeat of 2018 would also have the S&P 500 end 2022 below 4,500. That’s not a perfect example in our view in that markets were also hit by the onset of the trade war which added on recession concerns. Though COVID continues to cause short-term economic disruption, many investors believe we are closer to the end than the beginning of that story, and it’s also well understood.
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- Takeaway #2: While we continue see Value and Cyclical sectors outperforming in the early part of 2022, we’ve lost faith in our expectation that Small Caps will also recapture leadership in early 2022.
- It’s important to understand that the Value/Growth trade and Small/Large trade were positively correlated until very recently. That positive correlation has suddenly flipped negative in early 2022.
- A lot of signals for small cap that have traditionally explained the small/large relationship quite well and have been signaling support for Small Caps are breaking down as well. We dig into five of these signals and speculate on why they are breaking down.
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- The first is improving COVID trends. The relationship we saw last year - Small beating Large when the rate of change in US COVID cases was trending lower – isn’t holding up anymore. This is probably due to the perception that smaller companies have a tougher time managing through COVID disruption than Large Cap companies.
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- The second broken signal is attractive relative valuations. Small Caps look deeply undervalued vs. Large Caps.
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- But a lot this is driven by lower quality micro caps and this is a point in the recovery in which we normally see a sloppy shift from low quality back to high quality.
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- The third broken signal is expectations for a strong economy in 2022. Small Caps tend to outperform when real GDP growth is tracking above average. But Small Caps are trading like economic growth is already below average.
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- We think this may be due to weak small business optimism, which tends to track Small Cap performance, and
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- also the fact that some key economic indicators like ISM mfg appear to have hit their cycle highs. Overall, the idea here is that that we’ve already seen peak economic optimism and there’s a negative undercurrent in terms of sentiment.
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- The fourth broken signal is interest rates. Small Caps tend to beat Large Caps when ten year yields are rising and
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- ahead of first Fed hikes. But this isn’t working as a signal either right now, possibly due to tapering (Small Caps underperformed Large Caps during the 2013-2014 taper) and
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- because Small Caps have at least a third of their debt in variable rate instruments.
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- The fifth broken signal is inflation. Small Caps normally outperform when inflation expectations are rising. We think this one isn’t working because Small Caps are seen as having a tougher time managing around this pressure.
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- There’s some evidence this is happening as Small Caps have been much weaker than Large Caps on the rate of upward EPS estimate revisions.
Our bottom line – we aren’t ruling out a Small Cap catch up trade, but think a better way to play the early year rotation is through Value and Cyclicals within Large Cap.
End with Industries in Motion page
That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBCs Industries in Motion, for a deep dive into specific sectors by RBC’s team of equity analysts.