Favorable Tailwinds for Growth Stocks
Oct 21, 2024
In its 4Q24 Outlook, Jennison Associates is optimistic about the continued resilience in growth stocks as the economy moderates.
RESILIENT BUT MODERATED PATH FORWARD
Markets ended the third quarter on a positive note as the tide of global liquidity lifted capital asset prices around the globe. Several of the most popular U.S. equity indices ended the period at or near record highs. U.S. equities remain underpinned by earnings growth, a resilient albeit slowing economy, historically low unemployment, and inflation trends falling back into pre-COVID patterns. Equity price appreciation has fared better than we initially expected through the first nine months of the year, and that has helped companies with above-average growth rates. We expect to see this trend continue as the pace of economic activity moderates.
The geopolitical uncertainties that existed at the outset of the year have only intensified. The U.S. presidential election looks to be a close contest without clear policy implications. Furthermore, control of Congress looks equally difficult to call. This dampens advance market shifts, which are often the case when wider election result margins are perceived to exist.
Despite the heightened geopolitical uncertainty, we continue to focus on company fundamentals and idiosyncratic drivers of growth, as we believe that will generate above-average growth rates, now and in the future.
SECTOR VIEWS
During the quarter, small- and mid-cap value stocks led, while large cap growth lagged. Large cap growth continued to lead market returns for the trailing one, three, and ten years. There was significant disparity among sector returns in the third quarter. Defensive and cyclical sectors led, with utilities, real estate, industrials, and financials posting the largest gains. Energy was the only negative sector, while information technology and communication services lagged.
Longer term, we believe the market will continue to favor companies with asset-light business models, high incremental gross profit margins, subscription-model revenue streams, disruptive products, large total addressable markets (TAMs), and faster organic growth with long runways of opportunity.
Following up on a very strong first-half of the year, the S&P 500 Index’s information technology sector was up 1.6% in the third quarter. This reflects continued better-than-expected fundamentals across a broad range of business models, mainly the artificial intelligence “AI” leaders, along with an improving macro environment—primarily lower inflation and the consumer holding up well. Additionally, we are seeing ongoing improvement in the forward discounting mechanism for long-duration equities.
Fundamentals are being driven by the disruptive opportunity for AI and the digital transformation of consumers and businesses, especially the mega-cap companies in the space that can invest heavily to stay ahead with innovation and disruption. The longer-term underlying strength in these business models and their secular revenue/profit trends remain solid and were highlighted across the overall sector’s reported earnings these past few quarters.
AI and the super-high-speed computing processing that it requires continue to drive accelerating demand across a broad range of chip and silicon companies. This also includes the software architecture players and cloud platform leaders, along with the high-end design and manufacturing/fabrication providers. Additionally, new AI data centers and their unique demands for power consumption and control/distribution, along with cooling and signal processing, are contributing to the rising demand. We expect to see AI use cases and applications spread from technology providers and developers to a wide variety of industries and companies that use these tools to increase competitive positioning through improved time to market, streamlined customer service, and accelerated efforts to harness data in increasingly sophisticated ways.
The S&P Composite 1500 Health Care Index advanced 6.1% in the third quarter, outperforming the S&P 500 Index’s 5.9% gain. Additionally, the Nasdaq Biotechnology Index advanced 5.0%. Over the trailing 12-months, the S&P Composite 1500 Health Care Index’s 21.6% return trailed the overall S&P 500 Index’s 36.4% gain.
The current macroeconomic environment seems favorable for defensive sectors, particularly health care, which has historically outperformed the broader market during periods following the first interest rate cut, yield curve un-inversion, yield curve steepening, and rising unemployment—all of which are present today. With earnings growth in health care expected to exceed that of the broader S&P 500 Index and the sector appearing attractively priced relative to the S&P 500 Index, there is potential for multiple expansion. Additionally, operating margins, which had previously been a headwind for the sector, have now stabilized, and we anticipate margin expansion in 2025 to outpace the broader market. Given these factors, we believe health care is well positioned for strong relative performance moving forward.
The financials sector of the S&P 500 returned 10.7% for 3Q24 versus the 5.9% return of the S&P 500 Index. All industries had positive returns for the quarter, led by insurance, capital markets, consumer finance, and financial services. Overall, the current credit quality and balance sheet trends are doing well for the sector.
Another positive is the recent 50 bps easing by the Federal Reserve. Commentary from Fed board members in the past three months emphasized the need to remain vigilant in the ongoing process of fighting inflation while recognizing the solid trends toward their sub-2.0% target. At the same time, they acknowledged the lagging impacts of the rate increases of the past 12 months that have yet to fully reveal themselves in economic growth.
Overall, the large money center, consumer finance, and superregional banks are significantly better positioned today across a broad range of balance sheet, capital, and risk management metrics. Valuations in the sector have normalized. We believe that tailwinds for future earnings growth will be primarily driven by solid revenue trends and credit controls, growing net interest margins, ongoing expansion of their fee-based business opportunities, and continued efficiency improvements through better use of technology. We are also seeing opportunities with solid fundamentals and attractive valuations in global alternative asset management firms, P&C insurance companies, and several digital payment and financial technology companies.
During the third quarter, the Alerian MLP Index (AMZ) was up marginally at 0.7%, underperforming the 5.9% return of the S&P 500 Index. The more diversified Alerian Midstream Energy Index (AMNA) advanced 9.7%. Oil prices dipped during the quarter on continued worries of new OPEC+ supply coming on in 4Q24, which was earlier than anticipated. However, prices again rebounded later in the quarter reiterating that OPEC+ will re-assess supply quota increases if prices are too low.
Natural gas spiked off multi-year lows as seasonal electricity demand expectations, along with the long-term need for new electricity generation, will benefit natural gas—the most environmentally friendly fossil fuel. Long term, natural gas demand growth and high cash returns to shareholders remain positive tailwinds for the sector, and recent bolt-on CAPEX projects have the potential to drive accelerated growth in 2025.
Over the longer term, midstream energy companies are expected to play an important role in our energy future. The global energy transition will require multiple sources of energy to be successful and hydrocarbons—especially natural gas—will continue to have a role, driving future demand not just for the commodities but for the essential logistical systems that move them. With physical steel in the ground, midstream energy infrastructure companies have difficult-to-replicate asset networks with high barriers to entry, and whose adaptability to transport other energy sources is underappreciated in our view. Management teams are increasingly aware of the role they will play in our energy future, focusing not just on the environmental impact of their operations but also on how their asset bases can and will be part of a greener future.
The utilities sector of the S&P 500 Index gained 19.4% this quarter, significantly outperforming the S&P 500 Index. The beginning of the Fed rate cut cycle this quarter has been a tailwind to the sector after experiencing headwinds from the lack of Fed rate cuts earlier in the year. A handful of Independent Power Producers and Utilities with the ability to grow generation have been the biggest beneficiaries. Continued investor enthusiasm for the strong outlook for generative AI-related data center power demand growth propelled shares of many utilities sector and energy midstream companies higher during 3Q24 due to rising expectations for forward power prices, regulated utilities electricity load growth, renewable energy development activity, and natural gas demand for gas-fired generation. We believe strong long-term fundamentals and still-reasonable valuations underscore the opportunity in the utilities sector.
While absolute performance has continued to steadily improve in 2024, the utilities sector had its worst relative performance in over 40 years in 2023 and that sector has been one of the weakest sectors over the past five years. However, even during the economic volatility of the past few years, the companies have continued to execute operationally and deliver strong earnings while also de-risking their portfolios. Continued solid execution, along with the potential growth opportunities from renewable energy investments, should help to drive the sector’s earnings going forward. In addition, despite investor volatility, the increase in power demand growth driven by AI presents both a challenge to meet that demand but also supports underlying earnings growth potential. Strong fundamentals and macro factors underscore the opportunity in the sector, especially given what remains a lower-than-average interest rate environment.
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Alerian Midstream Energy Index is a broad-based composite of North American energy infrastructure companies and is a capped, float-adjusted, capitalization-weighted index whose constituents earn the majority of their cash flow from midstream activities involving energy commodities. Alerian MLP Index is the leading gauge of energy infrastructure Master Limited Partnerships (MLPs) and is a capped, float-adjusted, capitalization-weighted index, whose constituents earn the majority of their cash flow from midstream activities involving energy commodities. S&P 500 Index 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. S&P 500 Financials Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) financials sector. S&P Composite 1500 Health Care Index comprises those companies included in the S&P Composite 1500 that are classified as members of the Global Industry Classification Standard (GICS) healthcare sector. S&P 500 Technology Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) technology sector. S&P 500 Utilities Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) utilities sector. Indices are unmanaged and an investment cannot be made directly into an index.
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