Market Update March 2022 – How About the Rest of Us?
CAPITAL MARKETS
“Should the parallels continue to “rhyme” further into 2022? We will see. But all expectations need to be held loosely when dealing with health, wealth, and politics.” Market Update, February 2022
With what we now know, we should have prioritized “politics” ahead of health (e.g., COVID) and wealth (markets and interest rates) in last month’s Market Update. Russia’s aggressive actions towards Ukraine have become the global issue of highest priority. The uncertainty and potential ramifications are serious and leadership around the world is at work to bring this war to an end. If there is a positive, we are witnessing a wide-reaching unification of countries around the globe in opposition to Russia’s actions. (As we share our thoughts on economic and market topics in these monthly pieces, we acknowledge the greater importance of the current humanitarian issue and our concern for all involved in the conflict).
For some time now, the globalization of commerce and financial markets has been a significant catalyst for the global economy, providing many benefits for commerce and investors. But greatest strengths can also be greatest weaknesses, as is the case now. Globalization has, generally, been a benefit for many countries and we are now experiencing the other side of global inter-connectivity. Two countries with relatively small contributions to the global economy are now the headlines for much of the world for both the humanitarian and economic challenges. And despite the relatively small direct economic impact of these two emerging markets, the concerns are significant.
First, the humanitarian aspect will take on various shapes. Latest estimates from Bloomberg suggest over 1.5 million refugees have fled Ukraine with 885,000 going to Poland and 406,000 to Belarus. Influxes such as these may have an economic impact beyond that of the receiving countries. This may well disrupt European economic conditions which, in turn, could have spill-over effects to other global regions. And this is playing out in real-time today.
Second, is the direct impact on inflationary forces such as rising commodity prices. The most notable of which, for the US consumer, being gas prices. Even before this conflict had risen to the level we see today, US gas prices were moving higher as many COVID-related restrictions were being rolled back and the economy was continuing to reopen. It’s too early to know if higher prices will persist (which could be the case even if there is a conclusion to the Ukraine/Russia conflict), but it’s far enough along to consider the possible impacts of persistently higher inflation. When the consumer thinks of inflation at the “pump” it’s often in the context of the cost to fill a vehicle. However, often overlooked is the impact of that same cost for commercial businesses and the need to pass though those increased costs to the consumer. Should higher gas prices persist, the pass-through of these costs may further dampen the consumer’s broader spending and become a drag on the economy. And, while this is the most discussed economic consequence of the situation, it’s just one aspect of this conflict.
Clearly there are many other facets of this conflict which could further disrupt the global economy, including the US. And our instinct is to try and discern what may happen within our paradigm of the situation at hand. But as other direct and indirect participants may not be operating under our general paradigm, we must judge the possibilities and probabilities of various actions of others and be prepared to respond.
CHART OF INTEREST: How About the Rest of Us???
In the depths of March 2020, it was hard to believe that markets would stage a comeback like that which we have seen. Despite health, political and economic stresses the markets found their footing (with a few bumps along the way) and powered forward, believing that the crisis could be overcome. With the support of policy officials to help smooth out the rough patches of the recovery, the U.S. market (as measured by the S&P 500 Index) returned 101% from the March 23, 2020 bottom through February 28, 2022.
Following outsized gains of this magnitude, investors may question if markets are ahead of themselves. Have future returns been pulled forward, setting markets up for a period of lackluster returns? Are stocks now expensive with elevated metrics such as the price-to-earnings ratio of the S&P 500 index at 22.5 (as of February 28, 2022)? Or could markets be making a shift from a “stock market” to a “market of stocks”.
As of February 28, 2022, the five largest companies in the S&P 500 Index accounted for over 20% of the index, represented just three of the index’s eleven sectors, yet contributed nearly 25% of the S&P 500’s total return from March 23, 2020 through February 28, 2022. In part, their influence greatly shaped the broader returns of the index and allowed investors to “just buy the market”.
But recent months suggest that the catalyst of improving economic growth is providing new opportunities in many sectors and themes and, importantly, with much more attractive valuations. The chart below shows the significant divergence between the five largest companies in the S&P 500 Index versus the remaining index constituents. The names are familiar, but the premiums are not. As of February 28, 2022, the five largest companies traded at an average of 40.5 times expected 2022 earnings while the rest of the index traded at an average of 15.8 times expected 2022 earnings.
Opportunities in the market are clearly changing. And, following big gains from now-expensive broad indexes and mega-cap stocks, investor’s growing interest in company fundamentals is evident. It may be premature to consider that this is a new regime, but shifting leadership in sectors and themes suggest a new heightened investor selectivity from within the “market of stocks”.
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