As investors begin 2022, an old adage comes to mind: "Everything in moderation." This phrase appropriately describes the current environment — a world of moderating gross domestic product (GDP) growth, moderating fiscal policy, moderating central bank support and moderating equity returns.
With everything seemingly in moderation, it's important to not lose sight of the entire saying: "Everything in moderation, including moderation." While many aspects of the macro economy and market expectations are moderating, one area that we think investors shouldn't be moderating is their investment exposure.
Over the past few months, investors have found numerous reasons to pull out of the markets. Many have been tripped up on concerns over taxes, interest rates, inflation and prices. They are anxious about the potential impact of higher taxes. They wonder what could happen if rates shoot up too quickly or if inflation stays elevated. They also worry about high equity market valuations. All this may leave investors uneasy about how much higher the market can possibly go from here. So let's address each of those potential investor concerns.
From a tax perspective, while the legislative path remains fluid, potential tax hikes may elicit market responses, if enacted. However, we believe that any market reaction will be short-lived.
Historically, the six months before and after the effective date surrounding corporate tax hikes realize a median return of 10% and 8%, respectively, both higher than the long-term median return of 8% over six months. We believe a strong operating environment will be a greater driver of corporate profitability than taxes and U.S. equity markets continue to be poised to achieve potentially record earnings over the next two years.
Rising interest rates are reflective of economic normalization and shifting monetary policy. With the Federal Reserve likely beginning its hiking cycle in early to mid-2022, we expect the 10-year yield to end 2022 at 2.0% and 2023 at 2.4%. Still, higher yields at these levels have historically remained supportive of equities.
But it's not just about levels. Markets are more sensitive to the speed of rate change. We believe equity markets can absorb higher rates, so long as the moves higher are slow and steady.
For inflation, near-term levels have increased sharply with our estimate for Core Personal Consumption Expenditures (PCE) ending 2021 at 4.7%, its highest level in 32 years. Most of the inflation overshoot has been driven primarily by supply chain issues, which we believe may abate moving forward. Over the next few years, we believe inflation should trend lower in the 2+% range as the statistical composition of inflation measurements may limit sustainable price pressures.
As for prices, markets have seen full valuations hold for the last decade, yet have historically been able to generate strong returns regardless. This phenomenon has been consistent throughout history — economic expansions have been good for equity markets. In the last four expansions, the median gain from the market bottom was over 400%. So despite high valuations and markets being up over 100% since March 2020, we believe markets have more room to run.
Knowing that, investors may think about the post-pandemic cycle in comparison to the pre-pandemic cycle. In the last cycle, the primary ingredients driving markets included very strong growth, falling interest rates, rising profit margins and low starting valuations. This enabled technology to outperform financials, U.S. dominance to persist and growth-style equities to triumph over value.
Investors who exploited the right factors found alpha. While these factors are likely to remain impactful, we believe different sources of alpha will likely drive returns going forward. As we transition into the post pandemic cycle, potentially decelerating growth, low interest rates, high profit margins and elevated valuations will alter the investment landscape. As a result, idiosyncratic, focused and global themes may become more prominent.
By idiosyncratic, we mean company-specific. In every new innovative wave, the pace of innovation has accelerated. Today, the pace of change is the fastest in history, with waves of innovation shrinking from 80 years for the First Industrial Revolution to 25 years for the Digital Revolution today. As a result, we believe that incumbent companies will continue to be challenged by those either driving change or adapting to it, leading to shortened corporate life expectancies. In 1980, the average seven-year rolling lifespan of a S&P 500 company was 36 years. By 2020, it was reduced to 21 years. Ultimately, we expect decisions on company ownership to become much more bottom-up in this low return environment.
In terms of focused, we think that more concentrated positions and objectives may have potential to outperform those with broader, less selective ones. We believe companies positioned for the new cycle, including those who innovate new technologies, disrupt old ones, facilitate social and economic change, or adapt to such change, are likely to benefit. Specifically, such businesses may demonstrate high research and development, as well as growth investments. Therefore, we expect the importance of finding companies most reflective of these post-pandemic themes to become a more powerful consideration in conjunction with macro factors, sectors and geographic concentration.
We believe the alpha opportunity is set to expand globally as well. There is no longer a geographic monopoly on alpha. We expect pricing differentials to narrow as the market recognizes Europe's shifting sector composition and earnings prospects. In 2022 alone, we forecast earnings per share (EPS) growth for STOXX 600 to be 6% — a convergence to the S&P 500's 8% EPS growth forecast. As leadership goes global, we expect alpha to follow; 33% of the companies we estimate to be well-positioned are located in Europe, nearly equal to the 35% located in the US.
So as we start the new year, investors will need to contend with “everything in moderation;” slower growth, less accommodative policy and lower equity returns on top of concerns over taxes, rates, inflation and prices. However, we believe the strong macro backdrop, led by above-trend GDP growth, remains supportive and markets have further room to grow.
