Secular Growth Demand Revives in 2022
Jan 18, 2022
Jennison Associates’ 1Q 2022 Outlook explains how a growth slowdown and valuation reset will impact equity sectors and revive demand for secular growth stocks.
Strengthening Case for an Economic Slowdown
We are nearly two years into the COVID-19 pandemic, and much remains uncertain. U.S. economic activity in 2021, as measured by GDP growth, rebounded remarkably after the pandemic-driven contraction in 2020. Low levels of absolute and real interest rates have been a feature of the economic landscape for the better part of a generation. The efforts to forestall economic collapse over the past two years have taken this accommodative policy to an extreme and driven inflation to levels not seen in half a century. Debates around the duration of both wage and goods inflation abound.
The final three months of the year were marked by the emergence of the Omicron variant of COVID-19, as well as heightened concerns over inflation, which led the Federal Reserve to announce an accelerated plan of reduced asset purchases. While equity markets closed out the year at all-time highs, curtailed fiscal stimulus, tighter monetary conditions, and higher inflation build a case for slowing economic activity in the coming year. Rising interest rates in many emerging economies are already acting as a brake to their growth, thereby strengthening the case for a U.S. slowdown. Navigating this environment has required a shift in behavior from policymakers, corporations, and individuals, alike.
Valuation Pressure to Ease as the Year Unfolds
Corporate earnings remained strong, finishing a year of robust recovery from pandemic lows. The effects of monetary and fiscal stimulus were visible in the record levels of household and corporate cash, which bolstered demand, and strength in capital expenditure. While supply chains remained tight, the worst of the port and logistics congestion showed signs of easing as the year ended.
We use the framework of secular growth to think about the future over our investment time horizon, as many pre-pandemic trends continue to hold or even gain pace. While we acknowledge that forecasting is unusually difficult in the current environment, we have identified drivers of growth that are not tied to U.S. GDP growth. However, we expect that the policy backdrop may lead to further valuation pressure, similar to that witnessed in the fourth quarter. Growth equities with high valuations underperformed meaningfully. Many of these shares were also at a peak in prices when concerns arose about the potential impact of rising interest rates on valuations. Many of the important beneficiaries of the pandemic are facing challenging year-over-year comparisons. However, we believe the impact from this comparison effect should ease over the course of 2022.
Sector Views
In the fourth quarter, real estate was the best performing sector benefiting from the reopening of the economy. Information technology followed closely behind. For 2021, energy led market returns, but real estate, information technology, and financials also performed well. Defensive sectors like consumer staples and utilities underperformed. Information technology and consumer discretionary maintained their leadership positions for longer time periods.
Led by the mega-cap companies, the S&P 500 Index’s information technology sector rose 35% in 2021 (and 17% in 4Q alone). Recent technology sector earnings reports continue to be strong, confirming the underlying strength in many companies and secular trends. We believe the market should continue to favor companies with asset-light business models, disruptive products, and faster organic growth in the current Covid-19-affected environment and as the world returns to normal.
Unlike the last 2009-2019 economic cycle, valuations are more reflective of these powerful secular trends, and market broadening is still in place given the large expansion in GDP growth expected for 2021 and 2022, along with the consensus views that higher rates and inflation are ahead (albeit from a very low starting-point). So on a go-forward basis, we can expect continued volatility and consolidation for the technology sector, both relative and absolute.
The pandemic has accelerated the adoption of digital technologies by several years, and we expect that many of these changes will be permanent. Companies are understanding that to remain competitive in this new environment, they must value technology’s strategic importance as a critical component of business, not just as a source of cost efficiencies. As a result, businesses are making the kinds of investments that are likely to ensure the trend’s perpetuation. This can be seen across multiple fronts: technology-heavy capital expenditures; ecommerce strategies; the enterprise transition to the cloud; direct-to-consumer business models; and software applications that extend across businesses.
While the healthcare sector of the S&P 500 Index performed mostly in-line with the overall Index in the fourth quarter (returning 11%), its 25% gain for 2021 lagged the broader market return of 29%. Although healthcare has faced headwinds over the past year, we believe the sector’s short-term underperformance can be reversed as investors place more emphasis on company fundamentals and the significant alpha generating opportunity that broad innovation in the sector can provide. Furthermore, we remain hopeful that, as we have finally received some clarity on drug pricing, the six-year overhang on the drug industry, in particular biotech, can be lifted. We are pleased to see that the most negative elements of drug pricing reform are now off the table, and we expect the final details of the reform to be manageable. More specifically, now that some “action” is 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 announcement of an FDA commissioner, should position healthcare well into 2022.
Financials returned 5% for 4Q21, trailing the 11% return of the S&P 500 Index. Nevertheless, for the full year 2021 financials outperformed the broader market 35% versus 29% for the S&P 500. Many of the longer-term macro concerns that plagued the sector and other economic/rate-sensitive areas of the market before the pandemic are still in place; the Fed has signaled that interest rates will remain at depressed levels at least through 2022, and there is still no certainty around whether a higher nominal environment can be sustained. The current backdrop remains favorable for universal banks and brokers/asset managers as the capital markets are robust and expenses well-controlled. Scale has become a competitive advantage, and we are positive on business models with a broad reach along with higher profitability metrics. Also, the potential for higher interest rates (especially with a steeper yield curve) translate into higher interest revenue and earnings for the regional banks, though this is largely priced into those stocks.
Despite being the best-performing sector during 2021, energy broadly has been a laggard for the last two quarters. Midstream was essentially flat in 4Q with the Alerian MLP Index gaining 55bps, while the Alerian Midstream Energy Index, which includes a broader group of midstream infrastructure companies as well as MLPs, fell 37bps. While a recovery is clearly underway, uncertainty as to the pace and timing of a full reopening of the U.S. and global economy may give investors pause as evidenced by performance this quarter. As economic activity continues to slowly ramp, stocks should increasingly price in not only the short-term recovery, but also the long-term positive benefits from the significant transformational corporate reform that has occurred over the past few years. All of which should spell better times ahead for the midstream group.
The utilities sector rallied in December to close 4Q21 up 13%, modestly ahead of the broader market of 11%. While finishing the year strong, utilities has been one of the worst-performing sectors over the past 12-month period, despite strong underlying fundamentals. In fact, even during this period of economic volatility, the group has continued to execute operationally and has been able to 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. The discrepancy between utility fundamentals and performance underscores both the attractive absolute and relative opportunity in the sector, especially given the lower-than-average interest rate environment.
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 500 Health Care Index comprises those companies included in the S&P 500 that are classified as members of the Global Industry Classification Standard (GICS) health care 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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