As is par for the course at the start of a new year, PLANADVISER Magazine has received a number of equity and bond market analyses from a host of investment managers and advisory firms.
Among these is an analysis penned by Barry Gilbert, asset allocation strategist for LPL Financial, which stands out for the simple reason that it takes time to look back at key lessons learned during 2021. According to Gilbert, in many ways, 2021 was a typical year for markets, but it also reinforced some basic market facts that are hard to learn, even if they are not new.
“As we launch into the new year, we’re highlighting three 2021 market lessons that we think may matter for 2022,” Gilbert writes. “These are as follows: 1) equity valuations are a poor timing mechanism; 2) structural forces have a large influence on interest rates and may keep them relatively low; and 3) politics and markets don’t mix.”
As Gilbert recalls, at the start of 2021, investors heard concerns that broad U.S. markets were overvalued using many traditional valuation metrics, such as the price-to-earnings ratio (PE). It was also commonly asserted that, compared with the U.S., international stocks looked relatively cheap. Despite these suggestions, the S&P 500 in fact surged higher in 2021, performing well above its historical average, while international equities lagged behind the U.S.
This basic dynamic underpins Gilbert’s first lesson re-learned: Valuations are a weak short-term timing mechanism.
“At the start of 2021, the PE for the S&P 500 was historically elevated at almost 22.5 on forward earnings, according to FactSet data,” he writes. “At the same time, interest rates were extraordinarily low, which makes stocks attractive relative to bonds and increases the present value of future earnings. On top of that, an extraordinarily strong year for corporate earnings helped stocks ‘grow into’ their valuations, with the PE actually falling to nearly 21 by the end of the year despite strong stock market gains. … The underperformance by international equities this year, which may have surprised some, also reminds us that valuations are not a timing tool. International stocks have been more attractively valued than U.S. stocks for quite some time and, yet, they’ve underperformed consistently for over a decade.”
Turning to interest rate considerations, Gilbert says the situation is complex and, in some ways, counterintuitive.
“If someone had told you at the start of 2021 that inflation (as measured by the Consumer Price Index [CPI]) would be up close to 7% over the year while real gross domestic product [GDP] would grow near 5.5% and asked you where the 10-year Treasury yield would be at the end of the year, most market experts would likely guess well above the approximately 1.50% where we ended the year,” he suggests.
Gilbert argues that one of the main reasons interest rates have stayed as low as they have was the amount of foreign interest into U.S. markets. Despite relatively low yields in the U.S., many foreign investors are still better off investing in U.S. fixed-income markets, he explains.
“With approximately $13 trillion in negative-yielding debt globally—it’s still crazy to think that you have to pay a country/company to own its debt—even modestly positive-yielding debt is an attractive option,” he writes. “So what is the key takeaway from 2021? Despite increased inflationary pressures not seen since the 1980s, there is still a huge global demand for safety, income and liquidity in portfolios and that has kept interest rates (and spreads) from moving much higher.”
Gilbert’s final lesson learned is that, at least in the short term, the goals and ambitions of political leaders do not necessarily lead to immediate changes in market performance.
“For example, when President [Joe] Biden was elected, one of the sectors most expected to suffer was traditional energy,” he says. “The bear case for energy was that Democratic policies toward fracking and the fossil fuels industry would further harm one of the worst-performing sectors over the past decade. In contrast, the solar industry was expected to benefit from an acceleration toward renewable and clean energy sources. Well, what happened? The complete opposite.”
Similarly, Gilbert explains, when President Donald Trump was elected back in 2016, the two consensus sector winners from his presidency were expected to be energy and financials, due to deregulation.
“However, from the date of the 2016 presidential election to the 2020 election, energy stocks were cut in half, while the financial sector returned less than half that of the broader market,” Gilbert observes. “Forecasters had the policy right and the business impact was generally as expected, but nevertheless it seemed small from a pure market perspective compared to other drivers influencing sector returns.”
Looking ahead, Gilbert says 2022 likely will not be a simple repeat of 2021, for a number of reasons.
“We’ve moved further toward the middle of the economic cycle, inflation is likely to decrease rather than increase, and economic momentum will probably slow,” he proposes. “But perhaps most importantly, the policy support from central banks and governments that have helped global economies bridge the economic fissures left by COVID-19 will likely begin to fade, leaving the economy to stand increasingly on its own two feet while putting more emphasis on the aggregate decisions of businesses and households.”