US Equity Market Outlook: Goodbye to 2021 transcript

Welcome to RBC’s Markets in Motion podcast recorded December 14th, 2021. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.

This week in the podcast, we recap some of the conversations we’ve been having with investors in December about our 2022 forecasts.

Two big things you need to know: (1) First, investors have been keen to discuss the downside risks to the stock market. While we’re still constructive on 2022, and are still looking for 5,050 on the S&P 500, we outline five things we’re concerned about regarding the broader market, which could generate volatility during the year, particularly early on. (2) Second, as we’ve discussed our view that Value, Cyclicals, and Small Cap will lead early in the year while Growth, Secular and Large Cap will lead late in the year, the investors we’ve been speaking with have wanted to explore what our thoughts are on the timing and triggers of that mid-year leadership shift.

If you’d like to hear more, here’s another seven minutes – a little longer than usual given it’s outlook season

    1. Takeaway number one. Investors have been keen to explore the downside risks to the stock market in our early December meetings.
      2. .
      • There’s been no change to our 2022 S&P 500 price target of 5,050 which we updated last month. That represents a 7% gain from the December 10th close and highlights how we continue to expect 2022 to be a year of solid but more moderate returns in the S&P 500 than what we’ve experienced in 2021.
      • Our target is roughly the average of 12 different models and tests that we run.
      • Most of our economic models, which bake in another above average year of GDP growth in 2022 – current consensus is calling for 3.9% right now are calling for a move to 5,100 or higher.
      • Meanwhile, two of three our models that look at stocks vs. bonds are calling for an 8% move on the year, and remind us that stocks still appear to be the best game in town, for at least a little while longer.
      • Our favorite one of these is our dividend yield test, which highlights how 46% of stocks in the S&P 500 are still offering a dividend yield in excess of the 10 year Treasury yield.
      • When asked about actual downside risks to the stock market, I’ve pointed to five things that we think are reasonable things to worry about, most of which could lead to volatility in the early part of the year.
        1. First, a more hawkish Fed than investors have been prepared for and its potential impact on valuations. The most bearish model among the 12 that we use to arrive at our price target points to a 2% decline on the year due to multiple contraction. This forecast assumes a 10% contraction in the S&P 500’s forward P/E, and incorporates our 2022 and 2023 EPS forecasts of $223 and $243. While multiples on this basis are often flattish or choppy over the duration of a hiking cycle, a 10% decline is the average low point seen if you start measuring at the beginning.
        2. Second, tough comps on earnings in the 1st half of 2022. Bottom up 1Q22 and 2Q22 estimates are tracking at 6% and 5% respectively, meaning there’s little room for error at a time when inflation and supply chain pressures may be improving a bit but are still likely to be intense.
        3. Third, expectations around the timing of supply chain improvements are also worrying us a little as we think about January/February forecast season. Our investor survey work suggests that many are expecting meaningful supply chain improvements to emerge around mid-year.
          • But trends in global COVID cases tend to lead freight rates, an important barometer of supply chains, by 1-2 months. Restrictions in Europe and Asia due to the Omicron variant could complicate the path of recovery.
        4. Fourth, if inflation trends begin to moderate (in terms of the rate of change, as some economists are anticipating), we worry that positioning in US equities, which has been quite stretched, at all-time highs on some studies, could also soften. Over time, equity ownership by US households net of cash and bonds as a percent of financial assets tends to track CPI over time.
        5. Fifth, politics. Mid-term election years tend to be positive ones for the stock market but well below trend. While stocks have benefited in recent months from the expectation that the mid-terms will be good for Republicans and bad for Democrats, it’s 11 months until election day and a lot could still happen. If Democrats’ prospects improve either because inflation pressures moderate or COVID fades, or for any other reason, this could pose a new hurdle for the stock market.
    2. Takeaway #2. As we’ve discussed our view that Value, Cyclicals, and Small Cap will lead early in the year while Growth, Secular and Large Cap will lead late in the year, the investors we’ve been speaking with have wanted to explore what our thoughts are on the timing and triggers of that mid-year leadership shift.
      • As a reminder, there are really four general reasons why we think Value, Cyclicals, and Small Caps will lead in the intermediate term, before Growth, Secular, and Large Caps take back over.
        1. First, Value, Cyclicals and Small Cap tend to outperform when GDP is running above average, as is expected to be the case in 2022, while Growth, Secular ad Large Cap tend to outperform when GDP is running below average, which consensus sees as a risk for 2023.
        2. Second, Value, Cyclicals and Small Cap tend to outperform ahead of first Fed rate hikes, while leadership tends to shift back towards Growth, Secular and Large Cap when hiking cycles start or shortly thereafter.
        3. Third, for now, valuations are more favorable for Value, Cyclicals and Small Cap relative to Growth, Secular, and Large Cap.
        4. Fourth, longer-term, high quality tends to outperform, and Growth, Secular, and Large Cap are viewed as higher quality parts of the equity market than Value, Cyclicals and Secular.
      • In terms of the more precise signals and the timing of the shift, there are really three things we’re watching:
        1. The timing of the start of the hiking cycle. Though the pivots can happen in the middle or end, the major leadership trades often inflect shortly before or after hikes start. Either lift off or the emergence of a new consensus on timing could be the trigger this time around. A March hike would mean the Cyclical trades don’t last as long as a mid-year or September hike would.
        2. Valuations. The cheapest stocks tend to outperform the most expensive stocks when rates are rising. This makes us think once the valuation gaps currently in place for Value, Cyclicals, and Small Caps closes, market leadership may be ready to shift away from those areas. It’s worth noting that Financials – the biggest source of market cap in the Value indices – still looks attractively valued vs. the broader market indices, but only modestly so.
        3. Positioning. The Growth trade currently looks highly over owned when we look at asset manager positioning in Nasdaq futures, as tracked by CFTC. We think we’ll need to see the froth out of the Nasdaq positioning data.
          • Similarly, Small Caps (where positioning is middle of the road at the moment) may also start to look over owned again when the Cyclical trades run their course.

That’s all for now, thanks for listening. And if you haven’t subscribed already, be sure to check us out on Apple, Spotify and other major podcast providers.