Growth Stocks To Rebound Amid A SlowdownGrowthStocksToReboundAmidASlowdown

In the second quarter, the health care sector declined 5.9%, which outperformed the S&P 500 Index that lost 16.1%.  Over the trailing 12-months, the health care sector rose 3.4% compared to the Index’s 10.6% decline. 

The investment environment at the start of 2022 was clouded by uncertainties related to the pandemic, inflation, and the prospect of slowing growth on the back of the Federal Reserve’s plans for policy tightening. As we move further into 2022, it is our view that the impact from COVID, coupled with many headwinds the sector faced in 2021, is subsiding. We believe the sector has begun to show signs of leadership again, as investors place more emphasis on stable company fundamentals and the significant alpha generating opportunity that broad innovation in the sector can provide. Furthermore, drug pricing legislation is back in the headlines. We continue to believe that the bills being discussed will be manageable and have a limited impact on the sector. We ultimately believe that clarity on drug pricing would remove a six-year overhang and be a long-term positive for the sector, in particular, biotech. More specifically, now that some “action” is potentially being taken on drug pricing the likelihood of any draconian changes that were potentially negative for the industry are off the table. A “no news” stance out of Washington, coupled with the appointment of an FDA commissioner, should position health care well into 2023. 

In what was a very ugly equity market (negative returns for all S&P sectors) in the second quarter, the financials sector modestly underperformed the broader market returning -17.5% versus the -16.1% return of the S&P 500 Index. While the expectation of Fed hikes was a tailwind for financials earlier in the year, this has since been offset by geopolitical conflict and inflationary pressure, which have given rise to concerns that we may be headed toward a recession. The sector would be negatively impacted if this occurred, specifically around higher credit losses and slowing consumer/business activity. This concern has showed up across all risk assets. Despite the negative return in the second quarter, financials have outperformed the S&P 500 Index by more than 400 basis points over the last 18 months. 

While the sector’s fundamentals are experiencing some labor cost pressures, this has been offset by the continued, albeit non-linear, economic recovery, improved tech-driven efficiencies, better credit conditions, interest rate hike announcements and the lingering effects of the second stimulus. Nevertheless, the market is less concerned with these dynamics and is solely focused on the expectation of a hard economic landing and the course of Fed tightening.  

Despite the gathering storm clouds, the current environment is supportive of banks from a relative basis given modest loan growth, improving interest income from rising rates, ample loan loss reserves, and credit conditions that remain solid enough to absorb some expected deterioration. Property and casualty insurance remains a safe haven given its defensive nature and strong pricing dynamics. Additionally, both industries have attractive valuations and reasonable earnings floors to support the stocks under a more difficult macro environment. 

Despite a negative return in 2Q, midstream infrastructure continues to be a strong performer in the 19 months since the COVID vaccine announcement in late 2020. While midstream—and energy broadly—outperformed the S&P 500 once again in the second quarter, energy was the worst-performing sector of the market in the month of June. Despite the fact that fundamentals and cyclical tailwinds remain intact, broader macro concerns as well as technical factors weighed on the group toward the end of the quarter. For the full three-month period, the Alerian MLP Index lost over 7%, while the Alerian Midstream Energy Index, which includes a broader group of midstream infrastructure companies as well as MLPs, fell by more than 8%.

Midstream energy has been a sector in transition for several years. Most of the larger companies have taken decisive measures to conserve cash and “right-the-ship” during this global pandemic, and we believe this disciplined behavior will continue. Cash-flow metrics have improved across the board after companies reduced capex and growth spending over the last two years. Many larger companies are now free cash flow positive for the first time, an important inflection point reached in 2021. Added cost reductions and increased asset optimization should continue to fortify balance sheets, while offering management teams further opportunities to reduce debt levels as well as return cash to shareholders. 

Recent weakness aside, improvements in fundamentals were finally starting to be reflected in stock prices. While a recovery is clearly underway, it will likely continue to be non-linear, as the world is still dealing with COVID and intermittent lockdowns in China. While it is likely that we have seen the last of severe global economic shocks due to the pandemic, hiccups along the way—whether pandemic- or geopolitically-induced—should be expected. However, as economic activity continues to ramp up, stocks should increasingly price in the long-term positive benefits from the significant transformational corporate reform that has occurred over the past few years. The group is well-positioned for performance beyond the cyclical recovery. 

The global energy transition will require multiple sources of energy to be successful. Hydrocarbons 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 infrastructure companies have difficult-to-replicate asset networks with high barriers to entry, and whose adaptability to transport other energy sources is underappreciated. 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.   

Following a rally that began in December of 2021, the utilities sector continued to outperform the broader market in the second quarter. Despite the relative outperformance, the sector posted negative returns. While concerns about rising rates, high commodity prices and an investigation into solar tariffs weighed on the group during the quarter, utilities continued to benefit from being a “safe haven” sector, which has helped drive both strong gains in the first quarter and relative outperformance in the first half of 2022. While utilities finished the period down 5.1%, the group ended the second quarter 1100 basis points ahead of the S&P 500.  

Utilities have seen a meaningful recovery in the last three quarters. The group had been the worst-performing sector on a trailing two-year basis prior to 2Q22, despite strong fundamentals. Even during this period of economic volatility, the companies have continued to execute operationally and deliver strong earnings while also de-risking their portfolios. The gap in performance has closed, with utilities now outperforming the S&P 500 by more than 6% over the last 24 months. 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, geopolitical concerns, as well as a flattening yield curve, remain macro tailwinds. Strong fundamentals and macro tailwinds underscore the opportunity in the sector, especially given what remains a lower-than-average interest rate environment.