Outlook 2022: US equities

• US economy is growing at a structurally higher rate than before Covid-19, driven by consumer spending, government infrastructure investments and corporate capital spending.
• Companies will be able to achieve higher revenue growth, and those that can protect their profit margins will be the biggest winners.
• In this environment, we believe the best opportunities will be found in small and mid-cap companies where growth and valuations are more attractive.

A combination of a strong backdrop for the US consumer, government spending (infrastructure and social bills) and corporate capital expenditure (capex) will lead to higher growth over the next few years for the US economy. This growth will be broader based and focused on de-risking supply chains, automation to tackle dependence on a tight labour market and emerging areas of the market to address climate risk.

This is in stark contrast to the last decade or so since the 2008 global financial crisis which was characterised by low growth and monetary stimulus coupled with government policy and regulatory uncertainty.

The post-Covid-19 economy in the US has been driven by consumer spending. However, we expect this to change as we move into 2022.

While the savings rate remains strong, the US consumer has spent their way down to a more normal level of savings from the post-pandemic historical peak. The US consumer will need to take on debt if the recent consumer spending trends are to continue. We also expect to see a shift from spending on goods to services as the reopening of the economy continues.

Companies set to invest more due to low cost of capital

The capex cycle being experienced in the US is noteworthy as it has been a number of years since companies have had the confidence to deploy long-term capital. Instead, excess cash was used to buy back shares, which provides a short-term boost to valuations but lacks the ability to compound.

Companies will be spending more due to the low cost of capital coupled with the fact that increased visibility around future growth prospects has boosted confidence in boardrooms.

In addition, companies are now more circumspect about their global supply chains, which means more focus and investment in the US and in nearby countries such as Mexico. Given the measures taken during the pandemic to ensure capital availability, there will be political pressure to invest rather than buying back shares or paying dividends.

Small and mid-cap companies set to benefit most

In this environment, US small and mid-cap companies are set to benefit more than large cap companies. This is partly due to the greater choice of companies participating in both the domestic US economy as well as more broad-based growth opportunities that did not exist in the past few years. As growth broadens out, the greater breadth and diversity of the small and mid-cap market will provide more ways to access that growth.

The future, however, is not all rainbows and unicorns as higher growth prospects come with the risk of more cost inflation. Although the supply chain bottlenecks and raw material cost inflation seen in 2021 may prove transitory, wage pressures will be more persistent as both skilled and unskilled labour remains scarce.

Protecting profit margins will be key as costs rise

Companies may enjoy higher revenue growth but those that can protect profit margins will be the biggest winners. Looking forward, valuations of companies will depend more on profit metrics and returns than simply nominal growth. This will require a lot of analytical skill to differentiate winners and losers.

The small and mid-cap segment of the market is poised to achieve superior earnings growth in 2022 than large caps. Although this has happened consistently for the past few years, large caps have outperformed small caps in recent years. This conundrum has left us with some of the most attractive valuations in small cap vs large cap since the financial crisis.

Higher interest rates could test some expensive valuations

The pendulum is likely to shift in 2022. A possible change in the interest rate cycle in response to higher inflation will test some expensive looking valuations for larger companies. Such elevated valuations are not so prevalent for smaller companies.

This apart, we see better growth anticipated by small caps in 2022, and if we are right about GDP growth remaining above trend, this will most likely come to fruition.

It is difficult to envisage markets generating the same level of returns experienced in the last year - which have been extraordinary - but the investment case is still strong for investors to make money.