This was a remarkable year for equity investors with roughly half of the stocks in the S&P/TSX Composite Index realizing double-digit gains.
However, investors may have to be more stock selective and tactical in 2022 as there are major positive and negative forces both at play. The bulls may argue that valuations remain reasonable for many stocks given the strength in corporate earnings growth, solid economic growth and an unemployment rate near prepandemic levels. In addition, interest rates remain low, merger and acquisition activity may pick up and COVID-19 antiviral treatments could become widely available in the near future.
Meanwhile, the bears may argue that the rapid spread of Omicron will crimp consumer spending and global economic growth in the near-term, inflation is high, the household debt-to-income ratio is near record levels, labour shortages and supply chain constraints persist in some markets and multiple rate hikes by the Bank of Canada will dampen demand for certain stocks.
So how can investors position their portfolios to make money in this environment?
To answer this question, I spoke with Kurt Reiman, senior strategist for North America at global investment management firm BlackRock. Here’s an edited transcript of our conversation.
The S&P/TSX Composite Index is up approximately 20 per cent in 2021 and it’s been a broad-based rally. What are your return expectations for the index in 2022 and what sectors do you believe will be the leaders and laggards?
Next year, we think returns from stocks will be positive but more moderate than in 2021, and I think it’s still largely earnings driven. This year, the Canadian stock market had strong earnings growth, even stronger than expectations, so the market actually cheapened over the past 12 months, which provides support for stocks next year.
As far as sector performance goes, I would say that it is likely to be a mix of sectors that will perform well.
There’s this ongoing debate about growth versus value and which will do better, and our impression has been for a long time that it is a mix of both. Within value or cyclicals, we are still in the midst of a restart, so we would look to sectors like energy and financials as still being in the driver’s seat next year.
But at the same time we think about secular forces that are underpinning earnings in certain sectors, like technology and health care, where they generate higher return on equity and they tend to be exhibiting operational excellence, balance sheets are strong and growth is still above trend.
So what would not do as well? In an environment where central banks are normalizing monetary policy and where the growth backdrop is still firm, some of the more interest rate sensitive sectors of the stock market, which tends to be the defensives, would end up trailing the broad market. So you can see utilities, for example, and consumer staples lagging the index.
Yet these defensive stocks can provide attractive dividends. Given the low interest rate environment, many investors need this income.
Financials is a sector that has the ability to grow dividends. Energy is generating tremendous free cash flow. We talk about technology, for example, as being a secular growth sector and yet it couldn’t be any more of a staple of our daily lives, especially after living through a pandemic. It is a sector that’s also generating ample free cash flow and is able to grow dividends more than before.
I would be looking to these sectors as sources of dividend growth and income and as an important piece of the portfolio, especially at a time when inflation is elevated.
You are bullish on stocks globally with an overweight recommendation for developed markets such as Canada, the U.S., Europe and Japan, and have a neutral recommendation on emerging markets. Do you favour certain country exposures?
We ended up spreading the overweight across the developed world pretty evenly because we saw less differentiation in economic growth and in earnings expectations.
The U.S. estimated 12-month forward earnings growth is at around 12 per cent, Europe is around 15 per cent, Canada is closer to 10 per cent. The earnings numbers seem pretty reasonable.
We looked at valuations and they don’t look particularly stretched. We compared valuations to their long-run historical average of the last five years or so. In the U.S., Japan, Europe and Canada, they are hovering right around their historical averages. Stocks are not particularly rich or cheap in all of these regions and that’s unlike the emerging world.
In emerging markets where, because COVID conditions are worse, central banks have had to raise rates against a more threatening inflation backdrop, [there are] concerns about currency weakness, profit growth is not as strong and valuations are not as forgiving.
Last year, by the way, we broke out China as a stand-alone allocation, no longer part of emerging markets. We take a positive view on Chinese stocks.
What are your thoughts on inflation and how can investors navigate this elevated inflationary environment?
There is room for inflation to move higher into 2022. We think inflation will eventually settle down but at a higher level because central banks are willing to accept more inflation. We think these conditions of higher inflation and low interest rates will prove to be a negative for nominal government bonds but positive for inflation-linked bonds and positive for equities, especially cyclical sectors.
Currently, four rate hikes by the Bank of Canada are anticipated by the fall of 2022 to help contain inflation. In BlackRock’s 2022 global outlook report, you stated that the Bank of Canada will raise rates sooner and faster than other developed regions. Can you comment on the pace of anticipated rate hikes?
The Bank of Canada will be monitoring the data and providing forward guidance to remove some of this emergency policy that was in place over the past couple of years. Fighting inflation is the pre-eminent goal, but this is not about aggressively containing inflation.
I think the Bank of Canada has its eye on the labour market. The labour force participation rate has moved back to levels that prevailed before the pandemic. Yet, there are pockets of the labour market that haven’t fully healed.
The fact that the economy has not returned to its level of output from 2019 and is still far away from trend should push against some of more hawkish interpretations of the bank’s policy environment. At the same time, debt loads as a share of GDP are higher – that’s potentially a constraint on efforts to normalize monetary policy.
Given your accelerated expectations of rate hikes by the Bank of Canada, this should bode well for the Canadian dollar.
I think there are limits, though. A Canadian dollar that’s too strong can end up being a constraint on export competitiveness. I think the Canadian dollar can move back above 80 US cents next year, but it’s pretty near fair value now.
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Jennifer Dowty