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December 2021 / GLOBAL MARKET OUTLOOK

Focus on Fundamentals

Equity valuations are vulnerable to rising interest rates. Slower U.S. earnings growth could favor less expensive, more cyclical ex‑U.S. mar

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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

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