Skip to main content

December 2021 / GLOBAL MARKET OUTLOOK

Focus on Fundamentals

Equity valuations are vulnerable to rising interest rates.

Download the outlook

Global equity markets demonstrated resilience in 2021, although the rise of the omicron variant put a damper on optimism as the year drew to a close. Looking ahead to 2022, the question is whether earnings growth will continue to support U.S. equity valuations that appear stretched in absolute terms.

Although signs of speculative excess abounded in 2021 in areas like cryptocurrencies and nonfungible tokens, the U.S. stock market did not appear to be in bubble territory, Page asserts. But equity valuations were a bit of a puzzle, he says.

  • As of mid‑November 2021, the price/earnings (P/E) ratio on the Russell 3000 Index was almost at the top of its historical range since 1989.
  • Relative to real (after‑inflation) bond yields, however, the index’s earnings yield was in the least expensive percentile for that same period.

“So I can say that U.S. stocks looked almost as expensive as they’ve ever been, but also almost as cheap as they’ve ever been, and both statements are technically correct if you look through the right lens,” Page observes.

Much will depend on the strength of earnings growth in an environment where the spread of coronavirus variants and the potential for rising interest rates both pose significant—if contrary—risks to the global economic recovery.

Throughout most of 2021, U.S. equity gains were supported by a steady stream of upward earnings revisions, Thomson notes. Despite a nearly 23% rise in the S&P 500 Index in the first 10 months of the year, the index P/E actually fell over that same period as earnings rose faster than stock prices.

If the recovery remains on track, earnings growth should continue in 2022, Thomson predicts. But with S&P 500 operating margins at a record level, U.S. earnings momentum is likely to slow. “The starting point for profitability is very high,” Thomson says. “It’s going to be a hard hurdle to beat.”

Beyond 2022, the hurdles look even tougher to clear, Thomson warns. “The next two to three years could be very difficult from an earnings growth perspective. At a minimum, we could well see below‑normal growth. But the stock market simply has not factored that in.”

Although Stocks Do Not Appear Expensive Relative to Bonds, Earnings Momentum Could Slow

(Fig. 1) Distribution of U.S. equity valuations and operating margin for companies in the S&P 500 Index

Although Stocks Do Not Appear Expensive Relative to Bonds, Earnings Momentum Could Slow

As of November 30, 2021.

1 Valuation measures are based on the Russell 3000 Index. Stock versus bond yield percentile has been reversed. The earnings yield is earnings per share divided by stock price.

Sources: Bloomberg Finance L.P., Strategas Research Partners, and Standard & Poor’s (see Additional Disclosures); data analysis by T. Rowe Price.

Slowing earnings momentum also is likely to produce more uneven results across companies, Thomson says, requiring investors to be more selective but potentially creating opportunities for active portfolio managers to add value for their clients.

Likewise, rising costs could put a premium on stock selection skill. “Companies that can pass through inflation should continue to see earnings growth,” Thomson says. “But for companies that don’t have pricing power, it could be an issue.”

The earnings picture for ex‑U.S. equities is more mixed, Thomson says. While earnings growth has been surprisingly strong in Europe, momentum in Japan has been slowed by a sluggish domestic economy.

Looking to 2022, however, Thomson suggests that Japan could offer potential relative valuation opportunities if the global recovery remains on track, as could equities, credit, and currencies in select emerging markets (EM). A contrarian case can be made for Chinese equities, he adds, as Beijing moves to restimulate an economy that appears close to stall speed.

Valuation fundamentals and cyclical factors could favor the “recovery trade” in 2022, Page says. Financial stocks, which carry a heavy weight in the value universe, historically have tended to outperform in a rising interest rate environment, he observes. And small‑cap stocks typically have done well during economic recoveries.

Companies that can pass through inflation should continue to see earnings growth. But for companies that don't have pricing power, it could be an issue.

- Justin Thomson, Head of International Equity and Chief Investment Officer

In a period of rising rates and higher inflation, the growth style could underperform, Thomson concedes. This could have implications for key growth sectors—technology in particular—that have led equity markets for much of the past decade.

“Companies that can grow earnings persistently over a long period of time are extremely rare,” Thomson says. “So I think the odds that technology will continue to be a dominant sector are rather low.”

Focus on Fundamentals

For illustrative purposes only. This is not intended to be investment advice or a recommendation to take any particular investment action.

IMPORTANT INFORMATION

This material is being furnished for general informational and/or marketing purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.  

It is not intended for distribution to retail investors in any jurisdiction.

Previous Article

December 2021 / GLOBAL MARKET OUTLOOK

Navigating Policy Shifts
Next Article

December 2021 / GLOBAL MARKET OUTLOOK

Growth Delayed, Not Derailed
202112‑1943807

December 2021 / GLOBAL MARKET OUTLOOK

Playbook for a Shifting Economic Landscape

Playbook for a Shifting Economic Landscape

Playbook for a Shifting Economic Landscape

Looking for Growth in Challenging Markets

By Sebastien Page, Justin Thomson & Mark Vaselkiv

By Sebastien Page, Justin Thomson & Mark Vaselkiv

December 2021 / MARKET OUTLOOK

Australia: 2022 Market Outlook

Australia: 2022 Market Outlook

Australia: 2022 Market Outlook

Transitioning from tailwinds to headwinds.

By Randal Jenneke

Randal Jenneke Head of Australian Equities

You are now leaving the T. Rowe Price website

T. Rowe Price is not responsible for the content of third party websites, including any performance data contained within them. Past performance cannot guarantee future results.