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by  Brad Willock Oct 13, 2021

In this video, Brad Willock, Vice President & Senior Portfolio Manager, North American Equities, discusses the current market environment for U.S. equities and shares his outlook for the next year. In particular, he explores the potential impact of tighter monetary policy and debt ceiling negotiations, and how he is positioning his portfolio in response.

Watch time: 10 minutes 46 seconds

View transcript

Are you concerned about current valuation levels in the S&P 500?

The valuation paradigm in the market makes things tricky. Historically, the market is expensive. It trades around 21 times next year’s earnings. And normally, that would be four or five turns lower over history.

And so, what’s important for folks to remember, though, is that valuation doesn’t do much to determine what forward returns look like in sort of one or two years out. It has a great deal to do with how returns shape up over 10 years.

So, one of the things that’s really affected valuations this last year is that the market was at 23 times about a year ago and is now under 21 times. The valuation has been getting cheaper but that’s because earnings have been so incredibly strong. Earnings have gone from $175 estimated at the beginning of the year, and now, this year’s earnings are estimated to be just over $200, so it has been quite a change there.

And I’ve been managing the portfolio, trying to keep it rather balanced with a little bit of growth and a little bit of value but centering on companies that have what we call a high-quality bias. And that is definitely the place to be in this kind of market.

Does the dividend universe appear more fairly valued?

The dividend universe is quite different than the market as a whole, since, for example, it doesn’t contain companies like Amazon that trade at very high valuations, or Tesla, or this kind of thing. A lot of internet software companies have very high valuations and high market cap, and so they do affect the index.

And in the dividend universe, it’s much more fairly valued, although it’s still not cheap. Parts of it are cheap. Places like banks, for example, energy, parts of materials, and even some industrials, but generally, it’s not historically cheap. But those areas are, and we are definitely focused the portfolio a little bit towards those areas.

How will the Fed tightening monetary policy impact markets?

So the Fed is expected to begin tightening, and that is to shrink the amount of bonds that it’s buying. We expect that to happen starting in November and end sometime in the middle of next year.

And it’s really important that investors realize that this is not a big deal. The Fed has been talking about it for a long time, investors have been talking about it for a long time, and we think it’s well-priced in the market. And the Fed has been standing on its head to make sure that nobody is surprised by this. And I don’t think anybody will be and, therefore, the market shouldn’t react very much.

What matters more is when they begin to raise rates and how fast they do that. Globally, interest rates are rising, especially coming out of many emerging market countries. Their central banks have been raising rates for a little while. And even Norway has gotten into it and started to raise rates.

And so, with the Fed and Europe and Japan and others still quite accommodative, but in the future, we do expect some rates changes out of the Fed. But that’s likely an event that’ll happen in 2023. So nothing to worry about for a while and it shouldn’t really impact the next 12 months.

What market themes are currently driving your portfolio positioning decisions?

Over the next year, the portfolio has definitely changed shape in anticipation of what we think will be a variety of changes. For example, we’re assuming that interest rates tend to go up but not a lot. I don’t expect them to rush up over 2%, for example. We also expect inflation to remain a bit uncomfortably high for a while but then ease back down towards 2% next year, perhaps in the back half of next year.

And then, we also expect that taxes, the tax rate, the corporate tax rate in the United States, is likely to move higher. And that is one of the biggest wild cards because if taxes do go up in the U.S., it’ll probably hurt earnings to the tune of about 5%. And that could cut earnings growth next year, which is expected to be around 9%, down to something in the low single digits. And I think the market would react negatively to that. I don’t see it well-priced in the market, but we would use that as an opportunity to add more into stocks, if the market does have a negative reaction to the passage of this bill where taxes head higher.

One of the other things we’re considering is that the U.S. consumer is in excellent shape. They’ve seen their home prices go up, their stock portfolios go up, but more importantly, the number of jobs available vastly outnumbers the number of people that are unemployed right now. Wages are going up at a mid-single digit rate and so we expect the consumer to actually do very well over the next 12 months. And so the portfolio reflects that anticipation.

We also expect companies to spend a good deal on capital projects and especially on technology to make themselves more productive. It’s hard to get labour these days. People are either retiring, a lot of folks are not going back to the labour market for a variety of reasons, and companies are being forced to adopt technology to help with productivity. So that’s actually quite exciting because the S&P 500 is highly levered to spending on software and technology and capital goods that allow a more productive corporate sector.

What’s your outlook for U.S. equities over the next 12 months?

So the outlook over the next 12 months is, well, it’s complicated. If you start with earnings, current expectations for earnings growth next year is about 9%, as I said before. But if taxes are raised, then we should probably think about a number closer to 4 or 5%. And then, valuations, as I mentioned, are high and are likely biased lower but only probably slightly lower. And that sounds to me like that comes together in about a mid-single digit or low mid-single digit return for the next 12 months.

The main risks to all of this, as I mentioned, are tax reform, which would be the biggest issue. If taxes, for example, are not raised in 2022, and they might be delayed until after the midterm elections in late 2022, in which case, if taxes are not an issue, then we could likely see much higher markets.

Another risk is that there has been some slowdown in China because of China’s policy to slow down, or at least lock down, large sectors and geographies of its nation when they have only handfuls or dozens of cases of COVID pop up. And so that approach is really causing China to slow. They’re also dealing with some credit issues and other things. And so, China is a risk factor.

Inflation’s another very large one. Like one of the biggest problems for corporates, some of them anyway at the moment, is supply chain problems. You may have read about containers that are stuck at Long Beach or LA and are empty and awaiting a ship to take them back to China. There are ports in China that are typically shipping out containers every day and they’re closed at the moment.

Twenty percent of all containers that go from Asia to the United States are in fact not moving right now, and that’s very strange. It’s caused prices to go up in terms of logistics, and a lot of things are in transit. For example, the average transit time from Asia to the United States is about 40 days, has been, but is now 80 days. And so that’s complicating life for a lot of companies.

Of course, COVID remains one of the biggest risk factors. And right now, we’re fortunate in that case loads seem to be dropping. Hospitalizations are also falling in almost all states in the U.S. And as a result, as COVID fades into the background and these supply chains work themselves out next year, then it’s possible that the outcome could be better or worse, depending on how those two things sort of shape up.

And lastly, probably always in the back of my mind, is the central bank. We have to keep our eyes on the Fed. If the Fed were to raise rates sooner or faster than expected, it might cause some trouble.

The bottom line is the economy should continue to grow for the next 12 months and drive revenue and earnings higher. And taxes likely are biased higher, and that leaves us with a mid-single digit return expectation for the next 12 months.

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