Regime Change: Low for Longer or the Return of Inflation?
QMA shares insights on events moving the financial markets.
A year after the COVID-19 pandemic devastated stocks and upended the world economy, global equity markets hover near all-time highs. Initially, growth companies benefiting from social-distancing policies led the rebound. With vaccines rolling out and interest rates rising, investors have shifted their focus to beaten-down value stocks, and growth stocks may appear less appealing. This rotation likely won’t last. If rates fall back to low levels, as largely expected, profitable growth companies developing disruptive products likely will regain market leadership. But even if they settle at somewhat higher levels, markets will gradually adjust to the new rate environment and then get back to the business of fundamentals driving market returns.
Jennison Associates’ Mark Baribeau, CFA, head of global equity, and Sara Moreno, emerging markets equity portfolio manager, discuss the recent market movements they view as transitory, why they favor transformative growth stocks, where to find compelling growth opportunities, and how active managers can help navigate the way forward.
Baribeau: We are clearly in a V-shaped recovery, with strong growth expectations for 2021. After the initial spike, global growth should moderate as the world faces the same pre-pandemic challenges, which may intensify given the flood of fiscal stimulus. Markets are expecting transitory spikes in interest rates, inflation, and economic growth in the coming months. We’ll see high pent-up demand in areas like travel and leisure as spending increases and economies reopen. But longer term, we believe structural deflationary forces—including technology, globalization, and demographics—will still outweigh the increase in money supply and supply chain tightness we are seeing. Pulling all the macro pieces together, we see a constructive environment for risk assets where we get reflation without runaway inflation. Combined with the prolonged “lower-for-longer” interest rate environment, the landscape should bode well for growth equities for the longer term.
Baribeau: Not really. While the recent rapid rise in the 10-year U.S. Treasury yield surprised markets, created short-term volatility, and pressured high-multiple growth stocks, we don’t see this as a game-changer for our investment thesis. Low interest rates since the global financial crisis certainly benefited growth stocks. However, they have also delivered strong returns during previous periods where the 10-year Treasury exceeded 2%—a level some experts believe to be a negative tipping point for growth stocks.
After all, earnings are the true drivers of stock performance and have been the reason behind growth stocks’ outperformance relative to other asset classes and investment styles. The world is changing, and COVID-19 is changing it faster, increasing demand for secular growth companies that are transforming our daily lives. Businesses and consumers are shifting their behaviors and actively seeking innovative products and services that are more productive, cheaper, faster, and convenient—and boosting growth for companies that can meet their evolving needs. If these businesses can continue to grow annual revenues and earnings at high double (or triple) digit rates, the yield on the 10-year Treasury—whether it’s 0.5% or 3.0%--becomes fairly inconsequential in their return calculations. In addition to high-growth companies, we also look for industry leaders that are profitable or have a strong path to profitability. We believe these companies can weather rapid rate changes better than unprofitable or speculative growth companies.
Baribeau: Global stocks returned 16% in 2020, making them appear expensive based on historical price-to-earnings ratios1. Unlike the last economic cycle from 2009-19, we believe current valuations also reflect powerful secular trends and are justified in the context of strong forward earnings expectations. As the recovery gains momentum and markets broaden, earnings growth forecasts are rising for equities. While cyclical stocks with cheap multiples will likely see a short-term earnings bump, this is unlikely to last given their significantly lower growth profiles. While huge pent-up demand may benefit cyclical stocks in the near term, some of these business models will need to change drastically to adapt to the post-COVID world, which will eat into their earnings. In the near term, we expect continued volatility and consolidation for secular growth stocks, but we believe companies exhibiting strong durable earnings growth can compress valuations quickly, validating their more expensive growth profiles.
Baribeau: To the contrary. We believe we’re still in the pre-game and that the real party has yet to begin. COVID-19 has accelerated massive secular transformations, but there’s a long way to go. For instance, despite strong gains in 2020, global e-commerce is only 16% of total retail sales. Cloud computing is approximately a $250 billion market with potential to grow into a multi-trillion-dollar opportunity2. Electric vehicles represented 2% of global auto sales in 2019 but are expected to reach 26% by 20303. Innovations in diagnostics and therapies are expected to permeate the healthcare industry and create revolutionary changes. These areas represent underpenetrated and enormous total addressable markets with long runways for growth.
Baribeau: We continue to find the most unique business models with the strongest durable growth profiles in the technology and consumer discretionary sectors. Going forward, we expect more equity volatility as markets adjust to the post-pandemic normal and will use periods of market weakness opportunities to add to our highest conviction ideas. We’re also investing in selective secular growth companies benefitting from a cyclical recovery. But as always, we’re focused on finding the next group of breakout growth stocks that will become industry leaders.
Moreno: Yes, but they require more patience. We see the recent weakness in high-growth emerging market companies as a compelling buying opportunity for investors who missed out last year and are looking to buy shares of innovative growth companies at discounted prices. Emerging markets are inherently volatile and react vigorously to sudden changes in interest rates and dollar movements. They typically perform well during the beginning stages of a new business cycle given their large exposure to cyclical sectors like financials, materials, and energy. That said, investors should be cautious about passively investing in emerging markets, which tend to have limited structural growth drivers and muted growth profiles. Despite the positive early-stage returns, passive investors are often disappointed in long-term emerging market performance, as more innovative companies assert their strength over cyclical sectors. With the huge populations and rising middle class incomes in emerging markets, we focus on new structural growth drivers and areas in these markets that are leapfrogging the innovation of developed markets. Investing early in these areas will be key to capturing the dynamism in emerging markets.
Moreno: Emerging markets are the world’s fastest-evolving economies. Investors expect that dramatically growing domestic consumption and a new set of domestic drivers in these markets will help raise their contributions to global gross domestic product. This demographic alone warrants some exposure to emerging markets. The rise of the global millennial is also upon us, as this generation will increase its share of global consumption. Asia has more than 1 billion millennials while Latin America is home to over 150 million4. This digital-native generation has shifting preferences at a time of huge technological change. Emerging markets are the breeding ground for many of the latest technologies revolutionizing consumption around the world. For instance, China’s e-commerce ecosystem is about three years ahead of the U.S., and its e-commerce penetration is 25% while the U.S. stands at 14.5%.5
1 Source: Morningstar Direct as of 12/31/2020; global stocks measured by MSCI ACWI.
2 Source: Statista as of November 2020.
3 Source: Statista as of March 2021.
4 Source: United Nations World Population Prospects 2019.
5 Source: Statista as of January 2021.
MSCI All Country World Index is a market capitalization-weighted index designed to provide a broad measure of equity-market performance throughout the world. It is comprised of stocks from both developed and emerging markets and includes approximately 23 developed and 23 emerging market country indexes. MSCI Emerging Markets Index is an equity index covering 23 countries representing 10% of world market capitalization. The Index is available for a number of regions, market segments/sizes and covers approximately 85% of the free float-adjusted market capitalization in each of the 23 countries. S&P 500 is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. It gives a broad look at how U.S. stock prices have performed.
Risks— Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, and political and economic uncertainties. Emerging and developing market investments may be especially volatile. Emerging markets are countries that are beginning to emerge with increased consumer potential driven by rapid industrial expansion and economic growth. Investing in emerging markets is very risky due to the additional political, economic, and currency risks associated with these underdeveloped geographic areas. Investments in securities of growth companies may be especially volatile. Due to the recent global economic crisis that caused financial difficulties for many European Union countries, eurozone investments may be subject to volatility and liquidity issues. Value investing involves the risk that undervalued securities may not appreciate as anticipated. It may take a substantial period of time to realize a gain on an investment in a small or midsized company, if any gain is realized at all. Diversification and asset allocation do not guarantee profit or protect against loss.
The views expressed herein are those of investment professionals at Jennison Associates at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. This commentary is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services. This commentary does not constitute investment advice and should not be used as the basis for any investment decision. This commentary does not purport to provide any legal, tax, or accounting advice. PGIM Investments LLC is a registered investment advisor with the U.S. Securities and Exchange Commission.
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1047002-00001-00 Ed: 04/21