Goldman Releases 2022 Stock Forecast: Diverges With A Bearish Morgan Stanley, Sees S&P Rising To 5,100
One day after the increasingly grouchy Morgan Stanley published its 2022 equity market outlook, in which it predicted that the S&P would close the coming year at 4,400, some 6% lower from current levels, as a result of multiple contraction emerging from higher yields and urged clients to exit the US and instead focus on Europe and Japan, Goldman overnight published its own far more cheerful view on where stock will trade in the coming years.
In keeping with its traditional bullishness, and with the S&P having recently surpassed the bank’s 2021 year-end price target of 4,700, there was little downside for the bank’s chief equity strategist David Kostin to continue the levitating autopilot, and he did just that, forecasting that the S&P 500 will climb by 9% to 5100 at year-end 2022, “reflecting a prospective total return of 10% including dividends.”
With multiples already stretched, Goldman said that profit growth – which accounted for the entire S&P 500 return in 2021 – will continue to drive gains in 2022. It sees S&P 500 EPS will rising 8% to $226 in 2022 and by 4% to $236 in 2023 (the bank’s EPS estimate is 2% above 2022 bottom-up consensus). Curiously, with companies consistently expanding profit margins despite input cost pressures and supply chain challenges, Goldman expects profit margins to rise another 40 bps to 12.6% in 2022 before declining by 20 bp in 2023 due to corporate tax reform.
Of course, Goldman’s base case will likely be wrong (as was its forecast in Nov 2020 when the bank forecast the S&P rising to “only” 4,300 despite predicting a “Roaring ’20s Redux“), and so it has also supplied two alternative projections: i) a faster growth and lower inflation than expected, would lift the S&P 500 to 5500, 17% above the current level; ii) Slower growth and higher inflation would reduce the S&P 500 by 25% to 3500. With the Fed set to hike at least twice in 2022, our money is on the latter, unless of course a market crash some time in the H2 of 2022 spooks the Fed and it promptly is forced to unwind its tightening.
And speaking of multiples, Goldman forecasts that the S&P 500 P/E multiple will remain roughly flat, ending 2022 at 21.6x, especially since after two years of near-zero interest rates, the Fed will likely begin hiking in July. And while 10-year Treasury yields will rise to 2% by the end of next year, Goldman believes that this will be offset by a declining Equity Risk Premium as policy uncertainty declines and consumer confidence rises. Strong corporate and household demand for equities will help support valuation.
(TL/DR): here are Goldman’s official client-facing Investment Strategies (for what the bank’s trading desk will actually be doing with the firm’s, and clients’ money, check back in a few days):
- Own virus- and inflation-sensitive cyclicals;
- Avoid high labor cost firms;
- Buy growth stocks with high margins vs. low margin or unprofitable growth stocks. Overweight Technology, Financials, and Health Care
For those curious for more, below is the investment summary section excerpted from the note:
For the last 30 years, declining interest rates have accompanied both rising equity valuations and higher corporate profit margins. The last 20 months have been no exception. The Fed responded to the pandemic by flooding financial markets with liquidity and pushing the funds rate to zero. Since the March 2020 trough, the S&P 500 index has more than doubled in a nearly uninterrupted upward trajectory to reach its current all-time high.
But the 2022 investment environment will be different in several important respects from the past two years. One aspect that will change next year is that the Fed will begin to hike rates in July. Real interest rates will also rise, solidifying the ceiling on valuation multiples and driving rotations within the equity market.
However, other aspects of the current equity market will persist. Real rates, while rising, will remain negative, and investor equity allocations will continue to establish record highs. In contrast with our expectation during the past year, corporate tax rates will likely remain unchanged in 2022 and rise in 2023. Or, as Kostin summarized it “Corporate earnings will grow and lift share prices. The equity bull market will continue.” We’ll see about that, but for now, here are Goldman’s key assumptions:
- PRICE: We forecast the S&P 500 index will climb by 9% to 5100 at year-end 2022, reflecting a prospective total return of 10% including dividends. Decelerating economic growth, a tightening Fed, and rising real yields suggest investors should expect modestly below-average returns next year. The S&P 500 has historically generated an average 12-month return of 8% in environments of positive but slowing economic activity and rising real interest rates, which describes our economists’ forecast for 2022. Counter to the intuition of many investors, the stellar 26% YTD return is not a good reason in itself to expect a weak return in 2022. Since 1900, the S&P 500 has generated an average 12-month return of 10%. Returns have actually averaged slightly better than that (+11%) following 12-month gains exceeding 20%, and only slightly lower (+9%) following 24-month gains exceeding 50%.
- SALES & EARNINGS: Earnings growth has accounted for the entire S&P 500 return in 2021 and will continue to drive gains in 2022. S&P 500 EPS will grow by 8% in 2022 to $226 and by 4% in 2023 to $236. Aggregate sales for S&P 500 index will rise by 9% in 2022 and 5% in 2023. Based on the current reconciliation framework, we assume Congress will enact tax reform legislation, but the increase in the effective corporate tax rate will occur in 2023 rather than in 2022. If the existing tax law is unchanged, it would add 200 bp to our 2023 EPS growth rate (4% vs. 6%) and our EPS forecast would equal $241.
- PROFIT MARGINS: We estimate that S&P 500 net margins will increase by 41 bp to 12.6% in 2022 before tax hikes compress margins by 18 bp to 12.4% in 2023. No near-term solutions exist to solve the supply chain and input cost problems that plague so many industries. However, managements have used price increases, cost controls, and technology to preserve margins, and many of the headwinds will ease in 2022. However, a tight labor market will persist and drive wage inflation. Our commodities research colleagues forecast Brent crude oil will peak at $90/bbl in early 2022 and then decline to $80 by year-end. Our economists expect annualized US GDP growth will decelerate from 4.5% in 1Q to 1.8% in 4Q 2022. During the same time, core PCE inflation will subside from 4.3% in 1Q to 2.4% by year-end.
- VALUATIONS: Gradually rising interest rates will offset an Equity Risk Premium that declines but remains wider than its long-term average, keeping the P/E multiple roughly flat at 21.6x at year-end 2022. The valuation of both the median S&P 500 stock and the aggregate index rank in the 90th+ percentile vs. history on a wide range of metrics ranging from P/E, to EV/sales, to EV/EBITDA, and P/B. However, the yield gap between the S&P 500 earnings yield (4.6%) and the ten-year Treasury note yield (1.6%) currently equals 301 bp, ranking in the 40th percentile vs. history. Our Dividend Discount Model-implied ERP of 5% ranks in the 30th percentile. We expect that declining policy uncertainty and rising consumer confidence will lower it to 4.6% by year-end 2022.
- MONEY FLOW: Households and corporations will be the key sources of demand for US equities in 2022. Households own half of the $28 trillion in US cash assets, an increase of $3 trillion since before the pandemic. We expect households will shift some of this capital into equities over time. On the corporate side, cash/asset ratios stand at record highs, and this year has witnessed record buyback authorizations exceeding $1 trillion. Foreign investors will also be net buyers ($100 billion) while mutual and pension funds will collectively be net sellers of $400 billion.
- ALTERNATIVE SCENARIOS: (1) Faster growth and lower inflation than we expect would lift the S&P 500 to 5500, 17% above the current level. (2) Slower growth and higher inflation would reduce the S&P 500 by 25% to 3500. Supply chain disruptions and inflation pressures easing more quickly than currently assumed together with strong consumer demand would support 10% EPS growth in 2022. While interest rates would rise, so would valuation multiples. Alternatively, worse-than-expected inflation pressures could weigh on consumer demand, damage profit margins, and lead to a more aggressive Fed than currently priced. This would lead to zero earnings growth in 2022 alongside a large decline in valuations. As our economists have highlighted, a key risk for US equities looking beyond 2022 will be a higher terminal fed funds rate than currently implied by markets.
- MARKET STRUCTURE: The highest degree of equity market concentration in decades means the path of the S&P 500 will be tied to the fates of its largest stocks. The “FAAMG” companies (FB, AAPL, AMZN, MSFT, GOOGL) account for 23% of S&P 500 market cap and 17% of earnings. These firms’ strong secular revenue growth, high profit margins, and elevated reinvestment rates have helped lift them to the top of the index. However, shifting tax and regulatory policy has increased the idiosyncratic risk these companies face, and therefore also the idiosyncratic risk borne by investors in the broad US equity market.
- INVESTMENT STRATEGIES: Own virus-sensitive cyclicals; avoid high labor cost firms; profitable vs. unprofitable growth stocks. (1) Own cyclicals, including “re-opening” stocks and those exposed to recent input cost headwinds that will benefit from accelerating economic growth in early 2022; (2) Avoid companies with elevated labor cost exposure given a tightening jobs market with the strongest wage growth in decades; (3) Own highly profitable long duration growth stocks and avoid fast-growing firms valued entirely on long-term growth expectations, which will be more vulnerable to the risk of rising interest rates or disappointing revenues.
- SECTOR RECOMMENDATIONS: Our earnings forecasts coupled with our macro model indicate investors should overweight the Info Tech, Financials, and Health Care sectors. Raise Financials to overweight on expectations of rising interest rates and strong economic growth in the first half of the year. Raise Health Care to overweight as declining policy uncertainty should help close the sector’s record valuation discount. Maintain long-term overweight in Information Technology on strong secular growth, high margins, and valuations in line with historical averages. Underweight “bond proxy” Consumer Staples, Utilities, and Telecom Services as well as the expensive Autos industry group.
A snapshot of the bank’s various scenarios:
In terms of macro assumptions, Goldman’s economists expect strong but decelerating US and global economic growth in 2022. Based on the bank’s top-down model, US economic growth accounts for roughly 50% of the variability in annual EPS growth. Kostin calculates that each 1% increase in GDP growth translates to roughly $7 of S&P 500 EPS; the bank’s macro earnings model also assumes the labor market will continue to tighten, 2-year and 10-year interest rates will rise gradually, and oil prices will decline by year-end 2022 after peaking at $90/bbl early next year.
Some more on Goldman’s earnings forecasts, which the bank sees rising by 8% to $226 in 2022, an increase of $14 from its previously published estimate of $212, and is driven by the bank’s expectations for continued margin expansion (this is where Goldman and Morgan Stanley differ greatly in their outlooks) as well as a “smaller-than-expected tax reform impact that should take effect in 2023 rather than in 2022.”
We lift our 2021 EPS estimate by $2 to $209 (+47%) to incorporate better-than-expected realized EPS growth in 3Q. We also raise our 2023 estimate by $10 to $236, reflecting 4% annual growth. The upward revisions can be attributed to our expectations of additional organic margin expansion and a smaller-than-expected tax reform impact that should take effect in 2023 rather than in 2022, as we previously expected.
Goldman’s top-down estimates are roughly 2% above consensus bottom-up estimates in 2021 and 2022 but below consensus in 2023, even excluding tax reform. Consistent with the recent trend, Goldman believes that analysts remain too conservative with their near-term forecasts, “as companies continue to leverage pricing power and cost reductions to withstand rising material and wage costs.” However, outside of post-recession recoveries, analysts are typically too optimistic with their forecasts, and Goldman (which is certainly subject to this optimism bias) expects this dynamic to resume by late 2022. The median revision to consensus EPS estimates during the last 30 years has been -8% (-4% annually).
Goldman also laid out its revised tax expectations, which now assume that corporate tax reform will reduce 2023 S&P 500 EPS by roughly 2-3% relative to constant tax policy. The Build Back Better framework indicated that most of the corporate tax provisions will take effect in 2023, not 2022 as previously assumed. Under current tax policy, Goldman forecasts 2023 EPS of $241 (+6% year/year growth). However, our new base case assumes the implementation of a 15% minimum book tax rate and a 15% “GILTI” tax rate on foreign income, which results in our revised 2023 EPS estimate of $236 (+4% year/year growth). Note that if passed, the proposed buyback excise tax would be accounted for as a reduction in equity, not a tax expense on the income statement, and therefore would have a de minimis impact on EPS.
From a sector perspective, Kostin expects that Information Technology earnings will face the largest headwind from tax reform. The tax proposals focus on firms with low effective tax rates and high foreign income which encompass many Information Technology and Health Care companies. The median Info Tech company has a consensus 2023 effective tax rate of 16%, with 34% of companies (representing 29% of aggregate Info Tech EPS) expected to have effective tax rates below the 15% threshold.
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Finally, looking closer at valuation, Goldman expects that rising interest rates will be offset by equity risk premium (ERP) compression and lead to a roughly flat forward P/E multiple in 2022. Goldman economists expect the nominal 10-year US Treasury yield will rise to 2.0% by year-end 2022, driven primarily by increasing real rates. If this forecast is realized, both nominal and real interest rates would still remain low by historical standards and continue to support the relative attractiveness of equities. The bank’s ERP model includes changes in 10-year breakeven inflation, the 10s2s slope of the yield curve, consumer confidence, policy uncertainty, and the size of the Fed balance sheet. Kostin forecasts the ERP will decline to 4.6% by year-end 2022 from 5.0% currently as investors gain clarity and confidence regarding the inflation and fiscal policy outlooks. This would still register modestly above the 45-year average.
Combining Goldman’s interest rate assumptions and its ERP model imply a forward P/E multiple of 21.6x at year-end 2022 compared with 21.8x today. As Kostin admits, the start of a Fed hiking cycle, rising real rates, and a decelerating economic growth environment suggest further absolute valuation expansion is unlikely, which is why Goldman is confined to forecasting EPS growth as the driver of higher stock prices. Even so, at 21.6x, the P/E multiple would rank in the 93rd percentile vs. history in absolute terms. However, relative equity valuations vs. US Treasury yields would still register as attractive compared with historical averages (46th percentile).
In effect, this entire note boils down to two things: the Fed model, i.e., rates are so low so investors have to buy stocks… and FOMO, or there is nothing else all that money sloshing around can buy. Focusing on the first, the chart below provides a sensitivity of S&P 500 forward P/E multiples to various interest rate and ERP scenarios. Investors remain focused on the prospect for a sharp, sustained rise in bond yields. The drivers of higher rates will determine the corresponding change in the ERP and the ultimate impact on the S&P 500 index level: Rising rates driven by an improving growth outlook would likely correspond with a declining ERP and represent less of a headwind to valuation than a large rise in real interest rates driven by a hawkish shift from the Fed. Of course, if the economy were to contract sharply then this pillar of Goldman’s forecast will be useless.
Those who wish to pick bones with Goldman’s forecast can do so with the next assumption namely that “the upcoming rate hikes will not derail the bull market, but the historical experience during Fed tightening cycles suggests further valuation expansion is unlikely.” Current futures market pricing anticipates a path of Fed tightening roughly in line with the bank economists’ expectations, for liftoff in mid-2022 (this was pulled forward by an entire year just a few weeks ago) and two total hikes in each of 2022 and 2023. Looking at the previous five Fed hiking cycles, P/E multiples were roughly flat from 6 months prior to 6 months after the first Fed hike. As Kostin notes, the path of multiples varied beyond the 6-month mark, highlighting the importance of the length and magnitude of the tightening cycle. Although the bank’s economists and rates strategists believe that policy rates will eventually exceed current market pricing, they expect the market to adopt that view gradually and do not expect a sharp repricing of rates in 2022. The risk is that should inflation persist, this is the weakest argument behind Goldman’s optimistic forecast.
This, then, brings us to the second and perhaps most important assumption behind Goldman’s optimistic outlook: the absence of attractive alternatives, which means investor allocations to equities should rise further into uncharted territory in 2022 (unless of course allocations to cryptos and other alternative assets take their place). According to Goldman calculations, nearly $220 billion has flowed into US equity mutual funds and ETFs YTD, a pace that will set a new annual record. Along with strong equity market appreciation, these inflows helped to lift the aggregate equity allocation of households, foreign investors, mutual funds and pension funds (collective owners of 84% of the US equity market) to a record 53% of their combined financial assets. According to Kostin, the alternatives to stocks are “understandingly unappealing” (we assume this includes cryptos which for those who can hold on to the volatility rollercoaster, is certainly not the case), with the return on cash effectively zero, the yield on 10-year US Treasury note just 1.6%, and tight IG and HY corporate bond spreads. As Goldman concludes, equity allocations typically increase most when consumer confidence increases, policy uncertainty declines, and growth expectations rise, suggesting that a strong 2022 macro environment could further support rising allocations.
In other words, continued low rates and FOMO will keep pushing stocks higher for another year.
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One final point,here are Goldman’s sector recommendations:
- Goldman recommends investors increase their exposures to Health Care and Financials from Neutral to Overweight and reiterates its Overweight allocation to Info Tech (translation: Goldman’s market desk will be selling these sectors to clients). Financials should benefit from strong US and global economic activity in early 2022 and the rise in interest rates that our economists expect next year. Health Care trades at depressed valuations that should recover as political risk eases. In addition, it is a rare sector that typically outperforms in environments when real rates drive nominal rates higher, which describes our economists’ forecasts for most of 2022: “We have maintained a long-term overweight position in the Info Tech sector since December 2016 and continue to find its elevated profit margins and secular growth profile attractive at valuations that appear reasonable relative to its fundamentals.”
- Goldman also recommends Underweight allocations to the Consumer Staples and Utilities sectors as well as to the Autos & Components industry group within Consumer Discretionary and Telecom Services within the Communication Services sector (again, this is what Goldman will be buying from its clients). Goldman economists’ forecast strong 4.0%+ annualized US GDP growth during the first half of 2022 suggests it is too early for investors to fully rotate into defensive sectors. Consumer Staples, Utilities, and Telecom Services generally struggle to outperform the index as interest rates climb. Within Consumer Discretionary, Automobiles & Components has historically been challenged in periods where growth was decelerating and rates were rising, as our economists expect will happen next year. The sector has recently outperformed and trades at an elevated valuation vs. history, suggesting it has already priced some improvement in supply chains.
- Investors should neutral-weight a variety of cyclical sectors including Materials, Real Estate, Industrials, and Energy. Goldman also recommends a neutral weighting to the Media & Entertainment industry group within the Communication Services sector as well as Consumer Durables & Apparel, Consumer Services, and Retailing within Consumer Discretionary
There is much more in the full report which is available to pro subs, and can be found in the usual space.
Tue, 11/16/2021 – 16:30
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