Recapping 2021 and Sharing 2022 Outlook
By TRG Advisors on December 20, 2021
The Year of the Rotation
At the onset of 2021, value/cyclical/reopen names outperformed secular growth as optimism grew that the vaccine rollout had the potential to end the pandemic. Then, in the 2nd and 3rd quarters of the year, the Delta variant sparked fear of slowing growth and the “peak growth” narrative generated a rotation back into growth equities. Q4 has been mixed, with the most recent rotation going back to favor value outperformance. Discipline and conviction in attractive valuation with quality balance sheets and secular growth opportunities was rewarded.
We leveraged a barbell approach all year to capture returns across diversified industries, and remained patient with our long-term investment approach. Energy, Financials, Metals/Mining and Consumer Discretionary fared well in 2021 alongside the FAANG+M group – the combination being the very definition of diversification. YTD: Energy (XLE) is up 44%, Financials (XLF) have rallied 31%, Metals/Mining is up 31%, Discretionary (XLY) is up 23%, Communication Services (XLC) is up 15%, and Technology (XLK) is up 31%.
Throughout the economic recovery, we’ve seen the resilience of the consumer – boosted by both fiscal and monetary policy support, and the pandemic’s impact on elevated excess savings and pent-up demand. November retail rales are +16.1% y/y, wages are higher, jobs are plentiful (11 million job openings) and homeowners have seen their equity surge +19% – promoting consumer confidence. In addition, manufacturing is having a renaissance with strong demand, lean inventories and pricing power.
Chart 1: Retail Sales Growth and Personal Income Levels Higher1
A Data-Dependent 2022
We’ll be keeping a close eye on many of the same datapoints that the Fed is watching as they form their new monetary policy in 2022. Many questions surrounding whether they’re behind or ahead of the curve will be answered with the economic data in 2022. We forecast elevated inflation, less stimulus, a tighter Fed policy and a slowing growth rate (although above trend). Through H1, we anticipate growth will be above-trend, but at a slower rate compared to 2021. Stronger labor markets and continued wage increases should improve consumer spending.
In H1, we want exposure to cyclicals, reopen ideas and financials – the latter will benefit from the steeper curve. We still like energy in a supply-constrained environment with significant cash flows from existing operations. Those cash flows are being reinvested towards sustainable, lower carbon projects that will make these companies a key part of a greener future. We like industrials as well for their role in helping to meet the significant demand for additional capacity, logistics and inventory builds. On the heels of impressive company free cash flow numbers and supply chain improvements, we anticipate capex to recover from the decade long lack of interest or priority. Lastly, health care is trading at cheap valuations, creating an opportunity to invest cash flows from COVID-related products into other products and pipelines. These new products should start to make headlines, drive revenues and dividend. We also like quality technology and the total addressable markets they offer. Overall, we believe 2022 will be a stock-picker’s market.
In H2 we could see more defensive shift in the market – much as we’ve seen in the past few weeks – due to tighter Fed policy and less stimulus. We’ll be watching the data all year long to see if we need to adjust our positioning. For now, we like our strategies, our process and valuation discipline.
Federal Reserve Policy Normalization
The Fed is on a path towards more normalization. Central banks across the globe have already begun to enact a schedule of interest rate hikes – including Bank of England, Bank of Japan and Bank of Russia. As ever, the key driver of the rate hikes is inflation. CPI started the year +1.4% y/y and November recorded +6.8% y/y. Core CPI (excluding food and energy) started the year +1.6% y/y and November recorded +4.9% y/y. We also believe the stickier parts of inflation like rents and wages will keep upward pressure on inflation – although not to the levels we are seeing now. Higher trend GDP growth and elevated inflation means the Fed should be changing course at this time – and they are.
Chart 2: PPI, CPI, ECI All Moving Higher and Contributing to Inflation2
Yields are higher and flatter than where they started the year; mostly because of the short end rising and the flattening that has occurred in Q4. With investment grade corporate and municipal yield spreads relatively flat in 2021, fixed income investors have reached for higher yields and high yield spreads have tightened by 50 bps (from 360 to 310). This volume consolidation towards high yield securities may place us on the precipice of something important happening in 2022. Our fixed income portfolio has found plenty of names with a little story that can generate more yield, without reaching for those yields in far more uncertain baskets.
Chart 3: U.S. Treasury Yield Curve YTD Change (Higher, Flatter)3
2022 Fixed Income Themes and Opportunities
As spreads have tightened and we have seen record inflows, the environment feels like bonds are being “priced to perfection”. Our economic outlook is positive, so we don’t see any huge derailment, but there is not a lot of room for errors or bumps in the economy.
The anticipated large paydown of debt didn’t happen in 2021 – it’s 9% higher – but corporate leverage isn’t higher because of the significant cash on their balance sheets and higher EBITDA. This will help fuel 2022 capex. We see opportunities in muni revenue bonds with some level of COVID exposure (i.e., airports, toll roads) and forecast higher capex being a driver for new corporate and muni issuances.
COVID-19: The Elephant in the Room (that just won’t leave)
Despite our efforts with vaccines, boosters, masks, lockdowns, etc., COVID continues to impact our daily lives and the economy. COVID is the underlying force behind shifting consumer behavior, supply chain challenges, labor participation, inflation and nearly everything else we’ve experienced in 2021. Omicron is spreading fast, but all signs indicate it’s much less severe for individuals who are vaccinated/boosted and data from South Africa indicates it may pass quickly.
Once we’re able to get past COVID, there are a lot of tailwinds likely in the economy, from better labor participation to more efficient global supply chains to more permanent demand for services like restaurants, hospitality, travel and leisure. We’re hopeful that the collaboration of science and data can once and for all push COVID-19 into the rearview during 2022. We’re optimistic and looking forward to a great 2022.