“The trend is your friend” is a popular adage and for good reason. Imagine you are driving on a straight highway and all of a sudden you’re surrounded by fog. Of course, you slow down but you also likely assume the road will continue in the same straight line you’ve been driving down—hopefully long enough for you to emerge from the weather. You certainly wouldn’t decide there is a sudden left turn…unless you want to end up in a ditch. Guessing the direction of a potential turn and timing, well, good luck. Investing is similar: there is always a substantial amount of fog and uncertainty about what lies ahead where the most likely path over the next month, quarter or year for the economy, the markets, or a specific stock is a continuation of its previous trend. This is known as the momentum factor at the individual stock level. More often than not, trends persist—that is why they’re called trends.
So, what is with the audacious title? While we are not 100% certain, there are so many macro and economic changes of direction likely to occur in 2022, we don’t believe the fog-obscured road will remain straight. We are more confident about some potential macro changes than about others, but change is afoot. Some macro forces have already started to shift, and others still may. We believe these changes will contribute to a disruption and even alter many pre-existing market trends, some of which have been running for many years.
Changing macro trade winds
Below are several key macro trends that have either recently reversed or have a good chance of reversing in the coming months, which could have a lasting impact on markets and leadership.
Pandemic – We have no added insight into the path of the pandemic, driven by new variants, vaccines, and R. We can see that despite the Omicron variant blowing daily infections to many multiples of previous peaks, the trend towards more normal behaviours continues. Perhaps it is fatigue, perhaps the world is willing to live with the risk. The December box office gross was roughly in line with the three-year average from before pandemic. Spiderman clearly skewed the results to the upside, but still, it was more or else pre-pandemic “normal.”
There are some big implications if behaviours continue on the path back to normal as 2022 progresses. For the past two years, spending behaviours have tilted away from services and towards goods, with a solid dose of increased savings.
Of course, we are talking total aggregates here. Spending on goods, from iPads to home renovations to cars, has been a boon for the earnings of the equity markets and large cap companies. The fact is $1 spent on technology hardware has a bigger impact on S&P or TSX earnings than $1 spent on dinner at a restaurant. It was this change in behaviours that has helped drive index earnings so high in 2021. And those savings piled into markets help them advance in price as well.
This can easily be seen in the relationship between S&P earnings and U.S. Corporate Profits, a measure across the entire economy not just the 500 members of the S&P 500. And this can be seen in the size of the U.S. equity market relative to the economy. The crux here is given the market is a market capitalized weighted index, the profits from that $1 spent on goods has an outsized impact on market earnings and valuations compared with $1 spent at your local pizzeria.
Service spending (e.g., pizza) will resume as we all increase our mobility, the timing of which remains uncertain. But we know spending on goods will likely slow. Most goods spending—iPad, home reno, car, etc.,—last a long time and don’t simply get replaced each year. This is why goods often carry the moniker Durable Goods, they last. That new RV or boat isn’t going to be replaced for some time even if you are not going out and spending on pizza.
As the pandemic-induced spending rolls over, a likely occurrence sometime this year is companies that benefitted from durable good spending may suddenly experience negative growth simply because the pandemic bump was so big. And given how those dollars were a boon for the equity market and equity market earnings, they could easily become a disadvantage.
Global Tightening Cycle– Since the financial crisis over a decade ago, monetary stimulus has become a driving force in the bond and equity market. Stimulus helps lift asset prices higher, as the stimulus slows or begins to be removed, markets fall, and central banks come back to the rescue with more stimulus. Call it the Fed Put or whatever you like, this has been the norm. When the pandemic hit, stimulus was poured on even harder: this time with fiscal spending to ensure the dollars landed in the economy.
We are not ambitious enough to suggest the Fed Put period for the markets has ended, but it will be more challenging. Piling on more stimulus in a disinflationary environment like in the 2010s is a much easier policy decision compared with adding stimulus when consumer prices are rising so quickly. The central bankers may be slower to come riding to the rescue of markets this go around with inflation as a bigger issue.
And if you doubt the connection between markets and stimulus, the recent market volatility can largely or at least partially be attributed to the removal of stimulus/liquidity.
Growth Deceleration – We have not come across the following words for many years but believe they are going to re-appear during 2022: “hard or soft landing.” Of course, this is how economist and market strategists talk when the economy starts to slow down or decelerate. Will it come in for a smooth landing back to around 2% growth or will it come in with a hard landing with growth slowing even more?
Keep in mind, economic growth will slow simply because it has been running so hot during the recovery from the pandemic recession. Add slowing growth with a dialing back of stimulus, and you get a challenging combination fraught with potential for economic policy missteps.
The markets have been riding ever-improving economic growth for the past year and a half. That pace is set to decelerate in the coming quarters. There will still growth, but at a slower pace.
Now what does it mean for markets?
The path is not known for any of the aforementioned macro forces, as we know things can change pretty quickly. However, at the moment, these changes are afoot and that will impact the more market-related trends. Below we have highlighted a number that we believe have portfolio construction implications.
Growth to Value or just not Growth
To say the last few years have been a typical market could not be further from the truth. In a normal world (whatever that is), growth tends to outperform value when earnings growth and/or economic growth is lower. Lower overall earnings growth in the market causes those companies that can still manage to grow earnings at an above-average pace to become more valuable. Think of it like a scarcity premium for growth.
When earnings growth is plentiful, most companies are growing nicely, so you can find growth just about anywhere: this is one of the core reason growth dominated value during the 2010-2019 period. Economic growth was sluggish coming out of the credit-driven recession. And earnings growth during the period was about 9% on average, compared with 14% and 17% in the previous two cycles.
You can also see this relationship looking at the average performance of growth vs value in years when overall market earnings growth or economic growth is above or below trend. When growth is abundant, value tends to win. When growth is scarce, the growth investment style wins.
This certainly does not explain 2021, which had very strong earnings and economic growth, yet the growth style outperformed value. The pandemic-induced behavioural changes had all of us, to some extent, spending more time at home, consuming more home media, upgrading our personal networks (WiFi…not circle of friends), less in person shopping, improving our homes and buying more gadgets. This disproportionately supercharged the growth investment style given the largest companies in the S&P 500 Growth index are Apple, Microsoft, Amazon, Alphabet, Meta, Tesla, Nvidia and Home Depot. Yes, Home Depot is #7.
This makes 2022 extra challenging for this growth outperformance trend to continue for three reasons. The overall economy is opening up, more in some countries than others. The first reason is that society’s desire to become more mobile again appears to be outweighing pandemic fears. The result is that spending will likely start to migrate away from pandemic-induced spending to more normal spending patterns. We are done spending money on WiFi, and if you purchased a car, RV, iPad, likely won’t be buying another one in 2022 or 2023. Even if spending patterns don’t rush back to normal patterns, the growth trajectory of pandemic spending has already or will likely crest in 2022.
At the same time, economic growth and earnings growth are expected to remain above average (those are the second and third reasons). True, they are both starting to decelerate but the economic pace of growth is still going to be pretty healthy in 2022. Add inflation, which helps value more than growth, and things are stacking up pretty good for this overall trend of the past decade to reverse.
Value or Just Not Growth – This is a bit more of a philosophical question. Value and growth is a standard approach to break the market down into two large groups based on a few factors. Usually earnings growth and/or a valuation metric. But there are other ways to slice up the market: quality, low volatility, momentum, size, etc. So, is this the time for value or is it simply just a really tough time for growth?
We are less confident answering this question. It could very well be the time for quality, or small caps have lagged considerably last year. It is an easier assertion that growth is more at risk given valuations (see the chart for more info), given market concentration, and given the previous points. And value remains reasonable value—plus after a decade of underperformance, there is a decent margin of safety, at least relatively.
Portfolio Implications – There will likely continue to be a battle for market leadership as this year progresses. After a decade of outperformance and such a high concentration of growth companies in many indices, especially the U.S., don’t expect growth to go quietly into the night.
If there is a longer-term rotation out of growth and into value, it will have a very negative impact on some markets and a positive impact on others. Canada and Europe, relatively, have much greater tilts towards value and less growth than many other markets. Go Canada!! Obviously, the U.S. S&P is a growth market, and we can see what happens when one of the big growth names stumbles after Meta (aka Facebook) missed and sent the market tumbling. In the U.S., tilting more towards dividend-paying companies reduces the growth exposure, or even using an equal weighted ETF has helped reduce the impact of the growth names that have grown to be giants over the past decade of outperformance.
USA vs World – Who will stand atop the podium?
Among world markets, it is no secret that the U.S. has ruled the past decade. The rapid growth of technology in America has propelled them over their global counterparts with authority since the ’08 collapse. On top of that, the markets are not the only thing the U.S. has led. The 2022 Winter Olympics kicked off last Friday, reminding all of us that the markets aren’t the only thing the U.S. dictates…perhaps more in the summer than winter Olympics. We felt a true inspiration to put our own spin on the USA vs. the world, and while we don’t see the United States Olympics dominance reversing anytime soon, there is a case to be made within the global equity markets. We believe the stage is set for 2022 to be the starting point for the return of an unloved market to have their time on the center podium.
Let’s take a ride back in time and look at just how significant the cycle trend is when comparing the United States with the rest of the world. In the late 1970s to late 1980s, international markets were the place to be led by Japan as it was leading the globalization trend.
Next came the U.S. tech boom in the ‘90s, and, whether right or wrong, many have cited similarities with it to today’s market environment. In the 2000s, the U.S. was dealing with two of the largest market corrections in history as well as a recession, leaving the doors open internationally for another period of outperformance, led by strong growth coming out of China.
That brings us to the most recent era, which is best described earlier in the report by the outperformance of growth stocks over value. Looking back over those 40 years, it has certainly been a see-saw battle between the United States and international markets.
Let’s also not forget, over that time frame the U.S. won 1,331 Olympic medals, which is over 100 more than the next country: Russia. While more of those have historically been won in the summer games, it’s challenging to find a period of weakness similar to the equity markets.
That brings us to today, and the magic question: “who will stand at the top of the podium over the next 10 years?” Even though international markets might be setting up for a strong period of performance, leaving something on the premise of “we’re due” is not a basis for decision making. Therefore, let’s look at some other contributing drivers towards our beliefs moving forward.
Current forward valuations are telling us that we can expect a stronger period of performance from international markets over the coming decade. Looking back over the last 15 years, the U.S. market is typically more expensive than Canada and our counterparts across the ocean. However, the U.S. market currently sits drastically higher than its historical median, leaving one to believe a reversion to the median is likely to come at some point. An advancement towards the median internationally would be the solution to bring us back into equilibrium.
Similarly, looking at international valuations relative to the U.S., we are well below the 15-year average, at levels not seen in those 15 years. Of course, this trend could continue, but the first chart shows that cycles are very real, and reversions do happen. Perhaps the fact that we have cheap companies outside the U.S. will initiate that reversal.
It is safe to say that one of the very first things taught in finance is the benefits of diversification. In your childhood, you can likely even remember your parents telling you not to “put all your eggs in one basket.” If everything goes according to plan, there are benefits to being concentrated. For proof of that, just look at (1) Olympic athletes who have certainly put all their eggs in one basket or (2) the U.S. market over the past decade. However, if things don’t go according to plan, you can get caught on the wrong side of a bad situation.
The flip side is also true. Diversification can cause underperformance in the short term, but over the long term, it reduces volatility, which smoothens out your returns. The current U.S. market is anything but diversified. Technology has grown to account for over 27% of the S&P 500 alone, while the top three sectors make up over 54%. In comparison, the world (Ex-US) is much more balanced; even with financials taking up 20% of the index, the top three contributors only make up 44% of the overall market. Reiterating earlier points, the U.S. market is also dominated by growth, whereas international markets and Canada are tilted more towards value.
The tilt towards technology and growth in the United States is for a good reason—the sector has outperformed year after year with investors beginning to enter the euphoria stage and question whether it will ever end. At a 27% weight, technology contributed towards 38% of the return of the S&P last year. Diving deeper than the sectors, only five individual companies accounted for 32% of the 2021 return. Once again, this trend could certainly continue, but it is safe to say that the risk level within the U.S. market is heightened.
The signs point towards international markets
There are many diversified investors out there right now questioning whether they should continue to hold this underperforming allocation in their portfolios. As challenging as it might be, that is the time to add to international.
Looking at markets historically, there is a strong relationship between starting valuations and future long-term returns. Cheaper valuations are cheap because they are unloved and abandoned by overly pessimistic investors, or in this case, overly optimistic U.S. investors. Over time those emotions will change, and those unloved companies will become loved once again.
The long-term chart of the USA vs. the world showed us what happens when a market becomes too concentrated. A difficult 10 years followed the S&P 500 after the index became dominated by technology. While not identical, this time feels similar to that environment of euphoria.
While revisiting your international allocations may not be as exciting as a Mark McMorris Triple Cork, we believe there is strong data to perpetuate a reversion of dominance throughout the next decade. The change of leadership will happen, the only argument that remains is when it will begin.
Services vs Goods
The shift to the experience economy, which had already been well underway when a novel coronavirus emerged in Wuhan, was momentarily replaced by a pantry-filling, home-remodeling, furniture-replacing, appliance-buying, big-toy buying spending spree out of nowhere. Full on “stuff” – the movement that was credited once to millennials – is now once again beginning to take hold.
We expect to see a continued unwinding of the shift to durable goods spending over the course of the year. Variant scares notwithstanding, consumers are once again spending on services, such as restaurants, sporting events, concerts, and even long-distance travel. And while the speed of this spending migration remains uncertain, it is safe to say the growth in durables/goods spending will likely slow regardless of the pace of service-spending growth. The consumer is in a very strong place, with high savings and an urge to return to normalcy.
The U.S. travel sector posted the biggest gain among industry groups in dollar terms in December, climbing 125% from a year earlier, according to point-of-sale data from SpendTrend. FirstData's SpendTrend tracks spending information from credit and debit cards used at more than 4 million U.S. merchants. The recent spending data revealed a definite shift over the past few months. The highest growth is centered around travel, leisure, and hotels with the lowest readings coming from non-store retailers, furniture/home furnishings, electronics, and appliances. Pretty dramatic shift in how households are spending their discretionary money today versus a year ago. Who needs another Chromebook or iPad when the travel bug is calling…especially since the Chromebook/iPad is still pretty new.
We see value in examining the long-term changes to consumer and business behaviour that should become increasingly evident as we move through 2022 and beyond. Shifts in trends are very difficult to call in real time. Initial monthly changes could just as easily be viewed as outliers. What the table above shows is that this trend shift is already well underway, but many portfolios may not be properly positioned for such a change.
One of the big issues is simply the makeup of the consumer discretionary sector. Based on market-cap the SPDR – Consumer Discretionary ETF has a 22% allocation to Amazon, followed by a 18% allocation to Tesla. A whopping 40% of the sector is in these two pandemic winners, but neither are directly exposed to the positive shift in experiential spending patterns. Investors can’t simply look at it by a purely sector perspective, an equal weight discretionary ETF is a slightly better option, but we would emphasize the need for individual stock picking to gain exposure to this trend.
A potential risk to service-based business models is the rising costs of labour. Wage pressure will remain an ongoing issue for company margins and an overhang near-term, which is why we prefer companies that can pass through costs to consumers. Pricing remains the key lever to help mitigate cost pressures. For now, price increases (aka inflation) appear strong enough to offset rising costs, helping maintain margins.
We expect service-based companies across multiple sectors including industrial to be relative winners. Orders placed with U.S. factories for durable goods fell in December for the first time in three months, pointing to a pause in capital investment at the close of 2021. One bonus of services is that they are less exposed to commodity price inflation and supply chain disruptions, which prove to be ongoing issues. It appears spending patterns are beginning to change.
The world doesn’t change overnight. However, given that the macro trends appear to be changing, this may disrupt previously strong trends, or in some cases, reverse their direction. From a portfolio perspective, this sets the table for a number of changing dynamics. Whether it is value over growth, service over durables, international over the U.S., change is coming. Leaning into these changes from an overall portfolio perspective, designed for the future not the past, may well differentiate winning vs losing portfolios.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
— Derek Benedet is a Portfolio Manager at Purpose Investments
— Brett Gustafson is a Portfolio Analyst at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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