In This Outlook
A Mixed Bag in 2021
U.S. stocks delivered stellar returns in 2021, but globally returns were more mixed. We saw double-digit increases in Europe and the U.K. and many emerging markets bourses. However, poor performance in China, driven by government regulatory crackdowns and property sector woes, dragged down the emerging-market index to negative returns. Japanese stocks were about flat for the year. U.S. REITs and commodities were particularly strong performers in 2021, benefiting from their status as real assets during a period when inflation surged to levels not seen in decades. Bonds mostly posted negative returns, as yields bounced around but generally ended the year at higher levels. In the U.S., for example, the 10-year Treasury yield began the year at 0.9% and ended at 1.5%. The entire increase, however, came in the first quarter when the yield hit 1.74% on 3/31/2021 and has since traded back down.
Solid but Slower Growth in 2022
The growth environment for 2022 looks to be supportive of risk assets. We believe above-trend global growth is still likely, although growth should slow from 2021’s torrid pace. The outlook for economic activity is somewhat clouded by the emergence of the Omicron variant. Experts are still studying the variant, and more data will be available in the coming weeks. However, at this moment, we believe Omicron is unlikely to derail growth next year. Rather, it is more likely to represent another economic speed bump in an ongoing expansion.
That said, we believe 2022 will be a more turbulent and less rewarding year for U.S. stocks in particular, as the Fed unwinds extraordinary monetary accommodation in response to above-trend growth, the rapidly falling unemployment rate, and elevated inflation. While solid economic growth is typically good for stock market performance, high valuations, elevated rates of inflation, and rising real rates seem likely to coincide with lower returns, higher volatility, and larger drawdowns than we saw in 2021.
International Stocks More Attractive as Profit Growth Moderates
We expect profit growth to continue but to slow from this year’s blistering pace. 2021 was a banner year for corporate earnings as profits rose globally by more than 50% due to several factors, including base effects, increased revenue from pent-up demand, operating margin expansion, and declining interest costs. Triple-digit earnings growth rebounds in emerging markets Latin America and EMEA were driven by sharply higher oil and commodity prices.
Given the tough comparison and expected slower economic growth, profit growth should come back to earth in 2022. U.S. and global earnings are expected to grow at a high-single-digit pace next year.
Equity valuation multiples had risen sharply over 2020 as earnings collapsed due to the COVID recession, while stocks prices rose sharply in response to unprecedented monetary and fiscal policy stimulus, and in anticipation of a rebound in profits in 2021. During 2021, valuations improved with price/earnings (P/E) multiples contracting as earnings growth in the 50%-70% range outpaced stock gains in the 10%-20% range. The forward P/E ratio on the S&P 500 Index, for example, has fallen to 21 from 24 at the end of 2020. While this is still elevated relative to its 10-year average, we do not view it as excessive given the current level of interest rates and with profitability for S&P 500 firms at a record level.
Outside of the U.S., market valuations are much more favorable. Multiples in non-U.S. markets have generally fallen more decisively than those in the U.S. from 2020 levels. Eurozone equities exhibit forward multiples not too far above the 10-year average, while U.K. (FTSE) and Latin American stocks are trading at significant discounts to the same measure. As a result of the much better valuation starting point, non-U.S. markets could see significant outperformance over U.S. stocks next year. However, this has been the case for several years, and the momentum still favors the premium-priced and higher-quality U.S. market. We are currently neutral on U.S., EAFE, and emerging-market stocks.
Neutral Positioning for Now
Similarly, valuation, higher rates, and elevated inflation should favor value and small-cap stocks over large-cap and growth. However, these conditions were in place this past year as well, and bets favoring value and small-cap proved difficult to time and delivered mixed results. In the U.S. large-cap space, value stocks charged out of the gate this year, besting their growth counterparts 18.4% to 1.6% through May. However, since then it’s been almost the mirror image with growth beating value 16.0% to 2.5%. Similarly, the small-cap Russell 2000 Index was also beating the large-cap S&P 500 Index at mid-year but is now trailing by a large margin. We are currently neutral on style and market-cap positioning in the U.S. but could shift back in the direction of small-cap and value stocks next year if we see more definitive signs that market sentiment is shifting in their favor.
Commodity futures stand out as one of the few major asset classes that remains historically cheap (it’s worth noting the Bloomberg Commodity Index fell nearly 75% from mid-2008 to April 2020), so even with this year’s strong performance, the commodity index is still nearly 60% below its prior peak. We think the pandemic marked the bottom in the secular bear market for commodities, and a new bull market should continue into 2022. Further, price gains should be driven by elevated inflation trends, constrained supply, (driven by a decade of underinvestment due to falling prices, environmental policies and ESG investing), and buoyant demand (due to economic normalization from the fading impact of the pandemic and past government fiscal and monetary stimulus).
Bloomberg Commodity Index is composed of futures contracts and reflects the returns on a fully collateralized investment in the BCOM. This combines the returns of the BCOM with the returns on cash collateral invested in 13-week (3-month) U.S. Treasury bills. S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index.
The views expressed herein are those of PGIM Quantitative Solutions at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. This commentary is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services. This commentary does not constitute investment advice and should not be used as the basis for any investment decision. This commentary does not purport to provide any legal, tax, or accounting advice. PGIM Investments LLC is a registered investment advisor with the U.S. Securities and Exchange Commission.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or forecasts presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and forecasts are subject to high levels of uncertainty. Accordingly, any projections or forecasts should be viewed as merely representative of a broad range of possible outcomes. Projections or forecasts are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
Jennison Associates and PGIM, Inc. (PGIM) are registered investment advisors and Prudential Financial companies. PGIM Quantitative Solutions is the primary business name of PGIM Quantitative Solutions LLC, a wholly owned subsidiary of PGIM. PGIM Fixed Income and PGIM Real Estate are units of PGIM. © 2022 Prudential Financial, Inc. and its related entities. Jennison Associates, Jennison, PGIM Real Estate, PGIM, and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.