Financial markets have begun 2022 with increased volatility and negative returns. The primary culprit has been government bond yields, which have moved to highs not seen since before the beginning of the pandemic. Investors are anxious that central banks may be aggressive in tightening of monetary policy. We will receive greater clarity soon as the Bank of Canada and U.S. Federal Reserve are set to make announcements within one week.

 

A significant portion of the equity market weakness has been focused in the technology sector and other growth pockets, where stock prices can be particularly vulnerable to swings in bond yields and interest rates. Another uncertainty factor is the fourth quarter earnings season, which is now underway. Below, we discuss why earnings may play a more important role going forward in driving equity returns.

There are two forces that typically drive stock prices: valuations and earnings. The former can be described as the value that investors are willing to ascribe to the earnings, cash flows and dividends that are expected to be generated by a business in the future. As expectations change, and factors such as interest rates rise and fall, so too can the valuations that investors are willing to pay. Not surprisingly, valuations have moved higher for global stocks over the past decade as interest rates have declined.

 

Today, global equities are not inexpensive. Some markets around the world are trading above historical averages when looking at various commonly-used metrics, such as the “Price to Earnings” ratio. This was the case a year ago, and returns proved to be quite strong last year. Elevated valuations do not imply an imminent risk, nor do they suggest that returns cannot be reasonably attractive in the short-term.

Nevertheless, higher valuations do have important implications for investors. Historically, equity returns have been less robust over the intermediate term when the starting point for valuations has been higher, as is the case today. This is somewhat intuitive, as it is more difficult to justify valuations increasing significantly after having meaningfully done so over the past decade. As a result, investors may have to depend on earnings growth to drive positive equity returns going forward, rather than an increase in the valuation multiple that investors are willing to pay for stocks. In addition, any significant move higher in bond yields could reduce the multiple that investors are willing to pay, making earnings growth even more important. As a result, we expect moderated stock market returns going forward and that potential earnings growth will be the key driver of stock prices.

 

Fortunately, we also expect corporate earnings growth to be reasonably strong, barring any unforeseen headwinds to global growth. Consensus expectations are for close to 7% earnings growth for world public company earnings this year. This represents a meaningful decline from the nearly 50% growth in 2021, but last year’s numbers were skewed by the sharp recovery from the earnings decline witnessed in 2020. Earnings growth should moderate from the unusually strong levels seen last year, but should still be close to or above the historical trend. There will be upside potential if inflation moderates more than expected later this year, supply chain pressures ease, inventories get restocked and restrictions are lifted quickly.

 

The tailwinds of very low interest rates and bond yields are dissipating. This presents a challenge to asset valuations and will create episodes of volatility as financial markets reposition for a changing monetary policy backdrop. Nevertheless, we remain confident in the economic outlook and the prospects for corporate earnings growth over the months to come.

 

Should you have any questions, please feel free to contact us.

 

Drew M. Pallett, LL.B., CFP Senior Portfolio Manager and Investment Advisor   www.pallett.ca