The F.L.Putnam Investment Team weighs in on all aspects of the markets, and what to expect in 2022. Be sure to register for our Webinar on January 18, 2022, as several members of the team give an overview of the Market Outlook and take participant questions. A video of the Webinar will be posted after January 18, 2022.
- Macroeconomic Outlook
- Tactical Asset Allocation Positioning: At a Glance
- Equity Markets: The Great Bifurcation
- Fixed Income Markets: Year-end Summary and Outlook
- Sustainability Spotlight: Tightening the Reins
- Private Markets and Alternative Investments
- Market Diary: Recap of market activity in the last quarter of 2021
The most common word used to describe 2022 by forecasters is “transition.” As we said goodbye to 2021 and another great year of equity returns, many of the tailwinds that drove prices higher will start to shift in the new year. These factors include government stimulus, both monetary and fiscal, global economic growth acceleration, inflation trends, and equity market leadership. You can include a mid-cycle election as well to add uncertainty to the mix. We expect continued elevated economic growth, and positive—but more modest—returns for 2022 given the high current level of valuations across asset classes. We do expect greater volatility of equity prices, however, which we hope to use to our advantage across asset classes. Fixed income should continue to struggle with rising interest rates and alternative investments offer a buffer to challenging fixed income and modest equity returns.
After a decade of highly stimulative monetary policy, the Federal Reserve (“the Fed”) has communicated that it will begin to reverse its monetary policy of purchasing treasury securities and keeping interest rates near zero. Markets will be watching closely to assess their impact on economic growth and inflation. The massive fiscal stimulus provided by the Federal government is also expected to swing from a positive to a negative impact on economic growth. The US consumer was helped through the pandemic by massive government stimulus, which allowed them to reduce debt and accumulate savings. As this situation reverses, it has a negative impact on growth.
These actions are complicated by the current inflationary environment. After a decade of inflation well below 2%, we are currently experiencing higher levels than we have seen in forty years, as charted below.
While the pandemic is responsible for supply chain disruption and labor shortage issues, it is difficult to forecast how much of a long-term impact remains after these issues are addressed. This may force the Fed to focus on quelling inflation, at the expense of economic growth. Markets tend to tolerate Fed increases until economic growth is impacted, but the current level of economic momentum may provide some flexibility for the Fed. While we see the US economy moderating off the COVID recovery rate of over 5% shown below, 2022 should still provide real growth well above averages of the last decade.
Rotation of market leadership is also likely. While interest rates have been historically low, investors who focused on long-duration assets, such as growth stocks, performed extremely well. They were also highly rewarded for staying focused in US-based companies as US growth firms grew at a substantially faster rate than international firms. These companies also benefited from a strong US dollar as investors from around the world flocked to the US as a safe haven. After years of outperformance, the US equity market is unusually concentrated in these large growth companies and the valuation of their shares seems extended.
The result is that we expect equities to benefit from continued economic expansion and strong earnings but move higher at a much more modest pace due to elevated valuation levels. While we acknowledge that smaller capitalization and international firms offer attractive valuations compared to large US firms, we will continue to look for a catalyst to invest more heavily in these areas. Security selection may provide more ample opportunities to enhance returns. Volatility during the year may also provide attractive tactical allocation opportunities.
Given our interest rate outlook, fixed income is likely to struggle overall and positioning within fixed income will be especially important. The speed and scope of reduced policy stimulus may be impacted by several factors in 2022: lingering COVID issues, slowing growth and inflation, and a focus on the labor market rather than inflation in setting policy. Corporations maintain strong balance sheets, which favor corporate debt over treasuries and shifts in the yield curve could present opportunities that have not existed for years of a relatively flat yield curve.
Alternative investments seem likely to provide attractive long-term opportunities in 2022 given the lack of appealing risk-reducing assets in a deeply negative real interest rate environment. Careful selection is required in this space given the flood of money into these areas in recent years. Selective portfolio construction and due diligence will be a differentiator in providing the risk reduction and enhanced returns investors seek in these investments.
The next twelve months will certainly be a transition, but we also view it as a year of opportunity. Rising volatility in capital markets, along with changing policy decisions by the Fed and Federal government will likely require more tactical changes to our strategy for the year ahead. We still see the economy moving forward at a strong pace, generating solid earnings growth for corporations, but tempered by rising interest rates from Fed policy and elevated inflation. Equities still offer favorable return expectations over other asset classes, along with more selective opportunities in fixed income and alternative investments.
Equity Markets: The Great Bifurcation
Sorrow for the deceased and hospitalized, fear of the tsunami of infections washing across America, and hope for some sort of light at the end of the COVID tunnel were – again – the bittersweet cocktail with which we all rang in the New Year.
Perhaps oddly to some, however, it was a fantastic year for equity investors. The Standard & Poor’s 500 Index (S&P 500) soared almost 29% on a total return basis, setting 70 all-time highs in the process, the most since 1995, when it set 77. More impressive and perhaps not widely recognized, 2021 was the third year in a row of eye-popping gains for the US stock market, as the S&P 500 had already registered 31% and 18% total returns in 2019 and 2020 respectively.
What accounts for this apparent disconnect between the extreme hardship on Main Street and the euphoria on display on Wall Street? In 2021, it was a wave of consumer demand fueled by the convergence of pandemic-driven, pent-up savings and reopening economies. That drove the S&P 500 earnings growth shown below to significantly exceed expectations.
Earnings are now estimated to have grown 65% vs. expectations of just 23% at the beginning of the year, representing the biggest upward earnings revision ever recorded. This kept stock investors piling in via record equity mutual fund inflows. Buttressing that was a familiar theme that’s been on display since early-2019 and is likely the primary driver of the S&P 500’s 100% total return over the last three calendar years: the fact the Fed kept its key short-term interest rate near zero all year long and didn’t even start talking about “tapering” (reducing its monthly bond purchases, which have helped keep interest rates low) until late in the year. That “easy” Fed policy helped keep both consumer and corporate borrowing costs low and stock valuations high throughout 2021.
At the end of the day, there may truly not be a better example than 2021 of the old market proverb that the stock market “climbs a wall of worry.” Global supply chain disruptions, spiking inflation, political gridlock, geopolitical dustups with China and Russia, historic equity overvaluation, and recurrent outbreaks of ever-more contagious COVID variants have all failed thus far to derail the bull market in US stocks.
Still, literally all the potential party-crashers above continue to stalk markets as we enter 2022, while perhaps the most crucial of all stock market trend-drivers—Fed interest rate policy—is now clearly changing for the worse. As alluded to above, the central bank recently signaled its intention to speed up the “taper,” (i.e., engage in a faster tightening of monetary conditions) as the headline Consumer Price Index (CPI) skyrocketed to a 6.8% annual rate, its highest since 1982. While the Fed is trying not to spook investors, its recent pivot does represent a relatively major shift in policy that sets the stage for actual increases in short-term interest rates in the not-so-distant future.
Importantly, this dynamic doesn’t necessarily mean the end of the bull market is nigh. Remember, the Fed raised interest rates nine times between late 2015 and mid-2019 during its last rate-raising and tapering campaign, a period during which the S&P 500 rose more than 50% on a total return basis. As such, our proprietary equity strategies remain fully—or near fully—invested despite no shortage of things to worry about.
What is changing incrementally is the character of our equity investments, based on the apparent new market regime marked by higher inflation and rising interest rates. The great growth stock run of the past decade, in which we participated successfully, ranks among the best of the modern era, right up there with the Tech Boom of the late 1990s. We all remember how that ended, but importantly, we’re not yet seeing broad market evidence that a decline of that magnitude is on the immediate horizon. However, growth stocks are now quite expensive. In fact, today more than half of the US companies with the best growth profiles trade at 100-plus times estimated earnings or have no earnings at all, while the S&P 500 overall trades at about 21 times estimated earnings. These expensive growth stocks are sensitive to changes in interest rates and have recently been demonstrating elevated volatility and downside risk on days when interest rates rise.
On the other side of the ledger, the US companies with the lowest valuations (“value” stocks) now trade at a more than 40% discount to the S&P 500 itself. These value stocks can be found across nearly every industry sector, although financials and traditional energy stocks represent the largest share. Not only are the valuations and theoretical downside risks much lower here than in the growth cohort, financial and energy companies, among others, actually benefit from higher inflation and interest rates.
It is this bifurcated nature of today’s US stock market, coupled with the Fed’s recent policy pivot in response to higher-than-expected inflation, that we feel is of most interest in 2022. If nothing else, this bifurcation allows one to stay fully invested in equities, while managing the downside risks associated with operating in a historically “expensive” stock market. To the extent it is consistent with each client’s investment objectives, our equity strategies are seeking to balance selected exposure to value stocks against our long-time holdings in big cash-flow-generating growth stocks.
Fixed Income Markets: Year-end Summary and Outlook
As the US economy re-opened and recovered in 2021, Treasury yields increased across all tenors. Along the way, fixed income investors grappled with the outlook for economic growth, the Delta and Omicron variants, as well as the Fed’s expected timeline for reducing monetary stimulus. Unquestionably, the biggest story of the year in the bond market was inflation, with the Consumer Price Index (CPI) on track to end the year up over 6% on a year-over-year basis. Even the Fed’s preferred measure Core PCE (Personal Consumption Expenditures), which strips out the volatile food and energy components, is up 4.93% year over year. Against this backdrop, the Fed started discussing the timeline for reducing its bond purchase program back in June and finally enacted this policy in November. As the Treasury market digested inflation, growth, and Fed policy, interest rates increased—but not uniformly—across maturities. With Federal Funds rate increases expected in 2022, yields inside of five years rose more than longer maturities, leading to a flattening curve. Overall, the demand for US Treasuries has been remarkably resilient in light of the highest inflation readings in forty years. The low level of interest rates is truly a sign the market believes runaway inflation is temporary, and the Fed can engineer a soft landing for the US economy. In a year where economic growth was surging, riskier sectors of the fixed market outperformed, including high yield and preferred stocks. Rising inflation led US Treasury Inflation-Protected Securities (TIPs) to a second consecutive year of exceptional returns, while improving credit quality and the fear of higher tax rates helped municipal bonds outperform most other fixed income sectors.
Valuations are elevated in fixed income sectors such as corporate bonds (Investment Grade, High Yield) and mortgage-backed securities, yet when compared with the low yields of US Treasuries, their value proposition remains intact. For example, the current yield to worst of the Bloomberg US Corporate High Yield Bond Index is 4.68%, well below its five-year average of 5.69%, but this is still three times higher than the yield on a five-year US Treasury. Within corporate credit, fundamentals remain strong with high yield default rates below 2%, financial leverage below pre-COVID levels, and corporate issuers with record levels of cash on their balance sheets. In the municipal bond sector, finances are also healthy as cities, states, and towns collect strong tax revenues. Including 2021, Moody’s credit rating upgrades in the public finance sector have exceeded downgrades in six of the last seven years. Municipal bond valuations currently look stretched, but investors are still drawn to the sector’s safe-haven status. In addition, the tax-adjusted yields still make sense for investors that expect to be in the top income tax brackets.
As the Fed continues to tighten monetary policy in 2022, it has a difficult task trying to satisfy its dual mandate of stable prices and maximum employment. Supply chain issues and excess demand have inflation at peak levels, but measures of unemployment and labor participation have failed to reach pre-COVID levels. The Fed must strike a delicate balance by removing enough stimulus to cool inflation while keeping the economy growing. As we transition to a more “normal” post-COVID environment, it is important to remember that the amount of monetary and fiscal stimulus that has been administered is anything but normal and may have unforeseen consequences. In an upcoming year of transition, after two of the most distinctive market years in recent memory, we are preparing for elevated volatility that will likely lead to investment opportunities. The convergence of Omicron, elevated inflation, and tightening credit conditions may create a challenging environment early in the year, which compels an allocation to high-quality, liquid, government securities. Beyond that, as robust US economic growth continues in 2022, fixed income sectors that offer additional yield over Treasuries are likely to outperform once again.
Fixed Income Focus: A Banner Year for Green Debt Issuance in 2021
According to Bloomberg, green, social, sustainability, and sustainability-linked corporate and government bond sales rose to $1 trillion in 2021, which is a massive 108% increase from 2020. Bonds specifically labeled “green” totaled $527 billion compared to $246 billion in 2020.
While the US has lagged Europe in ESG integration and issuance, there have been some recent notable developments. In November, Ford Motor Co. sold $2.5 billion of green bonds, the largest green bond deal ever from a US corporation (Bloomberg). The proceeds will be used exclusively for clean transportation projects and for the design, development, and manufacturing of its battery electric-vehicle portfolio. In the municipal sector, green debt issuance could be boosted by the Infrastructure Investment and Jobs Act, which will encourage municipal governments to undertake previously shelved projects. 2022 will undoubtably be another booming year for green debt, with issuance even spreading to the High Yield and Emerging Market sectors. Notably, we are finding instances where the yield difference between green and traditional bonds is negligible and will look to add them to client portfolios where appropriate.
Sustainability Spotlight: Tightening the Reins
By all accounts 2021 was a big year for sustainable investing, with asset levels and the number of investment options reaching new heights. Issuance of green bonds and sustainable finance notched another record and there were numerous public listings of environmentally aligned companies through IPOs and special-purpose acquisition company (SPAC) mergers. Outside of the public market spotlight, capital formation in private markets continued to run hot, with impact investing a rapidly growing area.
We’ve hit a tipping point in global investment and financing systems, where participants have realized that the structural shift toward a more sustainable world is underway. Consumers are more sensitive to the sustainability profile of the companies from which they purchase goods and services. Governments are becoming more ambitious with frameworks to support the transition toward a sustainable future. Investors are increasingly allocating capital to companies properly managing ESG risks and delivering products and services that meet environmental and social challenges. Companies of all sizes are responding, proactively or due to investor pressure, with greater transparency and accountability.
With tremendous growth and progress across underlying market drivers, a lack of consensus around basic terminology has become a much more significant source of confusion and risk. There were many headlines in the news about greenwashing and misaligned expectations around ESG ratings and desire for impact. All of this has standard setters and regulators paying attention. The CFA Institute released ESG Disclosure Standards for Investment Products in November of 2021, and the SEC created a Climate and ESG Task Force focused on issuer disclosures and ESG investment product and strategy marketing.
As we look forward, we believe 2022 will be the year where market growth and product development will be put to the test as standards and regulations take shape. While we could list many items to keep an eye on for 2022, there are five major factors that should be on investors’ radars:
- Getting closer to a common language. The CFA Institute ESG Disclosure Standards for Investment Products outline terminology recommendations broadly covering ESG Integration, screening, thematic investing, and impact investing. We expect the investment industry to begin aligning with these standards in 2022.
- Improved corporate reporting. The SEC is working through public comments related to climate disclosure and has indicated broader changes covering a wider range of ESG topics to improve transparency, consistency, and comparability of information. The days of glossy CSR reports are numbered.
- Greenwashing becomes seriously risky. The SEC division of enforcement is actively evaluating investment manager ESG claims and marketing materials to ensure these are accurate and consistent with internal firm practices. Substance and true expertise will stand apart in 2022.
- Corporations will have to execute on commitments. The number of companies with carbon-neutral targets more than doubled in 2021 and now investors want to see action and real progress toward goals. Credibility of targets and action plans will be in the spotlight.
- ESG integration in private markets. A group of large private equity firms and institutional asset owners (investors) launched an effort to aggregate and standardize ESG data across private companies. ESG integration is likely to become a significant area of focus in private investment diligence in 2022.
The five factors above indicate that the sustainable investing landscape is shifting from early-stage growth to something more mainstream and moving from the why to the how. As the market changes we are not standing still; we are working hard to apply our sustainable investing framework to a broader set of investment options with our new teammates from Atrato and are developing an expanded set of sustainable reporting capabilities, among other initiatives. All of this is an effort to stay leading edge for you, our valued clients. We look forward to sharing more about our expanded platform throughout 2022.
Private Markets and Alternative Investments
Private markets investment opportunities remain compelling, but they are not immune to the risks associated with a rise in valuations that have gradually spread across most investible assets following unprecedented fiscal and monetary stimulus. While we are optimistic on the potential for carefully curated allocations, each area of private investing has some asset class-specific risks to be evaluated by investors in the current environment. For private equity strategies broadly (venture capital, growth, and private equity), the major considerations are timing and valuations. Interest rates, growth assumptions and discount rates are key contributing factors as well. In general, current frothy conditions are favorable for later-stage investments that will be exited imminently, while valuations on new investments imply a lower margin for error. For private credit and real asset strategies, the quality of credit and collateral underwriting are the most important factors. While both strategies are expected to be impacted by slower economic growth (increased losses/defaults), the quality of the underwriting should dictate the number of defaults and recovery upon default. With these risks in mind, our current outlook for each area of private investment markets is summarized below.
Market conditions for private equity remain broadly ebullient, with venture and growth investors being the most optimistic (which is typical). As noted by the WSJ recently, capital flooding into the space has accumulated to $900 billion of dry powder across SPACs, venture capital funds, and growth funds, as of mid-December. Given this wall of capital, managers are competing for deals by applying rosy assumptions to the growth and ultimate revenue multiples of their venture/growth targets and high EBITDA entry multiples to cash-flowing private equity deals. For investors with existing portfolios, this bodes well as the exit environment to capture these assumptions is attractive. However, investors allocating their capital in 2022 and beyond are likely to be exiting into a different market regime with lower multiples applied to revenue/growth or cash flows. Across venture and growth strategies, we remain biased towards proven managers with long track records, prudent fund sizes, reasonable fees, patient allocation plans (vintage diversification) and substantial alignment (personal capital at risk) with limited partners. Our preference within private equity has been to funds executing in differentiated segments of the lower middle market where the entry multiples are the lowest. Lastly, we are keen to capitalize on de-risked opportunities where investors can enter funds that are marked-up due to prolonged capital raises and capture appreciation on early investments at cost.
The outlook for private credit remains strong, but with greater expectations for dispersion over the coming decade than the last one. At the heart of this viewpoint are the vastly superior yield and capital appreciation opportunities that exist for investors who can sacrifice liquidity and the associated meager income offered in public credit markets. Since the Global Financial Crisis, bank disintermediation has been the major theme. While banks eliminated profitable non-core financing businesses in the face of greater regulation and tighter capital ratios, those teams sought to establish themselves independently. This exodus created an asset class that was not previously directly available to investors and allows for differentiated credit risk to be layered into portfolios. In the very near-term, the returns continue to look compelling with extremely healthy business and consumer balance sheets. However, beyond the near-term we have a varied outlook depending on the specific type of end-market risk. For example, within middle market direct lending, conditions are increasingly competitive as lenders to private equity-owned companies are dealing with compressed diligence timelines and a race to the bottom in credit terms (covenants and yields). This competition will manifest itself in lower returns in terms of nominal yields and loss-adjusted yields (weaker covenants make for weaker recoveries in distress). As such, our preference has been toward differentiated corporate lending strategies that embrace complexity (non-sponsor backed borrowers) for better deal structures and returns and short-duration strategies across asset types (capital solutions, mezzanine construction lending) where the lenders are offering a unique service, and therefore can set terms.
Real Estate & Real Assets
Real estate and real assets remain compelling. While highly competitive, new real estate opportunities are abundant as capital moves aggressively to the Sun Belt to capture COVID-related migration trends. Competition is particularly fierce within the multi-family space, which has proven itself to be a resilient asset class over the last several decades. That said, forward returns on core real estate projects have been bid down to cap rates of 4%, so forward return potential has clearly declined. As such, investors looking for appreciation have moved towards development stage strategies and/or asset-types with greater growth profiles, namely digital infrastructure and other infrastructure/logistics assets. As the digital economy continues to expand, the growth prospects supporting these deals appear justified. Aggregation strategies across property types or build-to-core strategies that seek to capture cap rate compression as they sell to the largest investors (pensions, insurance companies, public and private REITs) that can finance themselves the cheapest also remain compelling.
We view real assets as an extension of a client’s private credit strategies. The underwriting here is driven by the quality of the underlying asset (How long is the useful life?) and the credit risk from the lessor (How critical is it to the lessor’s operations?). If the quality of the underlying asset is high, and the credit risk is moderate-to-low, we believe investors can generate pre-tax returns that exceed those in private credit. In addition, these strategies typically provide beneficial after-tax characteristics owing to depreciation of the underlying assets. The general view across managers is that interest rates will rise and weigh on returns. In response, managers are utilizing current low rates to term out their debt and to finance their assets more efficiently through securitization and insurance structures. These financing arrangements should insulate returns over the next several years from changes in interest rates and isolate performance to the fundamental credit quality of the lessors.
Market Diary: Recap of market activity in the last quarter of 2021
|Global Market Returns – December 31, 2021||Last 3 Months||Last 12 Months*||20-Year Annual Return**|
|US Equities||S&P 500 (Large US Companies)||11.03%||28.71%||9.52%|
|S&P 400 (Mid-size US Companies)||7.97%||24.73%||10.54%|
|S&P 600 (Small US Companies)||5.59%||26.74%||10.70%|
|Russell 3000 (All US Companies)||9.27%||25.64%||9.71%|
|Dow Jones US Real Estate Index||14.58%||38.99%||10.39%|
|International Equities||MSCI World Index ex-US (Developed Markets)||3.21%||13.17%||6.97%|
|MSCI Emerging Markets (Emerging Markets)||-1.24%||-2.22%||9.95%|
|MSCI World ex US Small Cap (Developed Markets Small Companies)||0.45%||11.54%||10.11%|
|Fixed Income||Bloomberg Intermediate US Govt/Credit TR||-0.57%||-1.44%||3.78%|
|Bloomberg US Corporate High Yield Total Return||0.71%||5.28%||7.83%|
|Bloomberg Intermediate Corporate Total Return||-0.56%||-1.00%||4.82%|
|Bloomberg US Intermediate Treasury TR||-0.57%||-1.72%||3.24%|
|Bloomberg US Treasury Inflation Notes TR||2.36%||5.96%||5.30%|
|Bloomberg US MBS Index Total Return Value Unhedged||-0.37%||-1.04%||3.97%|
|Bloomberg Global Aggregate ex USD 10% Issuer Capped (Hedged)||0.80%||-1.64%||4.22%|
|J.P. Morgan Emerging Market Bond Index Global Core||-0.22%||-2.05%||8.14%|
|Bloomberg Capital 5-Year Municipal Bond||0.04%||0.34%||3.62%|
|Inflation||US CPI Urban Consumers Less Food and Energy NSA***||1.16%||4.93%||2.06%|
|Treasury Bill||US 3-Month Treasury Bill Index||0.00%||0.04%||1.32%|
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