Secular Resilience Amid Slowing Economy
Jan 20, 2023
Jennison Associates’ 1Q23 Outlook highlights long-term optimism for resilient, durable growth stocks and why they will weather a slowing economy.
LONG-TERM GROWTH REMAINS DESPITE CHALLENGING MARKET
Investors are grappling with the likelihood of recession in the U.S. and around the world. The ongoing war in Ukraine and frequently changing COVID policies in China remain unquantifiable risks. Persistent high inflation, resulting from the accommodative policies of the pandemic, has brought about a sharp reversal in monetary policy globally and an unusually abrupt tightening of financial conditions. In response, growth equities have gone through a grinding period of adjustment over the past 15 months. The starting point for the correction also coincided with high levels of absolute and relative valuations for growth stocks, resulting in significant underperformance.
The biggest retrenchment has occurred in companies that are not yet GAAP profitable, or where the pull-forward effects of the pandemic proved greater than we had modeled. The deceleration in revenue and earnings growth proceeded at a pace and scope beyond our forecasts. This trend was exacerbated by the strength of the dollar over the previous year and a half, leading to more negative translation effects than originally expected.
SOFTER EARNINGS GROWTH IN THE SHORT TERM
In the short term, we expect that fewer companies will generate earnings growth. We believe profit resiliency is likely to be as much a proxy for outperformance as expected growth under current conditions. We continue to focus on companies that have the products and services that meet today’s needs, while also investing for tomorrow’s opportunities. These businesses are well capitalized, against a backdrop of higher interest rates, and are likely to grow profitably at above-average rates over the balance of the cycle.
It has been nearly 15 months since the Fed announced its policy-tightening plans, and the market has adjusted to the new reality through sharply higher interest rates, lower growth expectations, and significantly lower stock prices and valuations. We expect greater clarity around the path of inflation, growth, and interest rates to emerge in the first half of 2023, accompanied by a bottoming in earnings expectations and sentiment. Our positive multi-year view incorporates the challenges that may continue to pressure the market in the short term.
All investment styles finished a volatile year with gains in the fourth quarter. For the quarter and calendar year, value outperformed growth across capitalizations. Large-cap growth was the weakest market segment. Energy, industrials, and materials were the best performing sectors, while consumer discretionary was the weakest sector followed by communication services.
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 (TAM), and faster organic growth with long runways of opportunity. This is especially true as the overall real economic growth is expected to slow back to its post-global financial crisis average. If this occurs, growth will become scarce again and the market will pivot towards the select few companies that can produce it organically.
In the fourth quarter, the healthcare sector of the S&P 500 Index gained 13%, outperforming the 8% return of the broader S&P 500 Index. Additionally, the Nasdaq Biotechnology Index rose 12%. Over the trailing 12 months, the healthcare sector fared much better than the broad market, returning -3% compared to the S&P 500 Index’s -18% decline.
While the healthcare sector has broadly outperformed year-to-date, it has largely been driven by larger market cap pharmaceutical, medical device and managed care companies that are able to fund their businesses with cash generated from operations. With that being said, the first half of the year was truly unprecedented for development-stage companies, as January and April were two of the worst months for the S&P Biotechnology Select Index in the past ten years. In the fourth quarter, trends began to reverse, as receding U.S. dollar headwinds and attractive growth prospects for select pharmaceutical, healthcare equipment & supplies, and biotech companies drove returns.
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 opportunities that broad health care innovation can provide. Furthermore, with the Inflation Reduction Act now in place, for the first time the Act brings the prospect of government mandated drug price controls, albeit for only a handful of the largest-selling products as they near patent expiry beginning in 2026. We believe the impact to the sector will be manageable as it only impacts the highest spending drugs covered under Medicare and does not impact the initial pricing of a new drug. Furthermore, with the Inflation Reduction Act being passed, we ultimately believe that clarity on drug pricing removes a seven-year overhang and can be a long-term positive for the sector, in particular, biotech. More specifically, now that some “action” is being taken on drug pricing, we believe any draconian changes that were potentially negative for the industry are off the table.
The financials sector of the S&P 500 Index returned 14% for 4Q22 versus the 8% return of the S&P 500 Index. Fundamentally, the sector continues to experience labor cost pressures, but this is being offset by improved tech-driven efficiencies and generally better overall operation of businesses (especially credit risk) by management. Nevertheless, the market is less concerned with these dynamics and is solely focused on the expectation of a future economic slowdown and the course of Fed tightening. For the quarter within the sector, mortgage REITs did the best (bouncing back in price return after a very difficult first three quarters), followed by insurance which has, by far, been the top performing industry group all year.
Despite the gathering storm clouds, from a relative basis the current environment is supportive of banks and capital markets companies 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 of these industries have attractive valuations and reasonable earnings floors to support the stocks under a more difficult macro environment.
For the full three-month period, the Alerian MLP Index gained just over 10%, outperforming the S&P 500 Index by 248 bps. Midstream energy continues to be a strong performer in the two years since the COVID vaccine announcement. Midstream—and energy broadly—outperformed the S&P 500 Index once again in the fourth quarter, though that was in large part due to outsized relative outperformance in October. While energy lagged almost all other sectors in what was a strong market in November, the group held up better than most other non-defensives in December’s weakness. Despite the fact that fundamentals and cyclical tailwinds remain intact, over the course of 2022 broader macro concerns periodically heightened and weighed on the group, and 4Q was no different. Midstream lagged all other energy sub-sectors during the quarter despite strong absolute performance.
Midstream energy has been a sector in transition for several years. Most of the larger companies took decisive measures to conserve cash and “right-the-ship” during the 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 past 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.
While it is likely that we have seen the last of severe global economic shocks due to the pandemic, the world has not completely moved past COVID, and China’s impending re-opening only creates more uncertainties. Add an ongoing war in Eastern Europe and recessionary concerns to the mix and continued hiccups along the road to recovery should be expected. However, as economic activity normalizes, stocks should increasingly price in the long-term positive benefits from the significant transformational corporate reform that has occurred over the past few years. Accordingly, we believe 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 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. 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 finished 4Q22 up 9% versus the 8% return of the S&P 500 Index. Utilities remained under pressure at the start of the period following a rapid rise of 10-year Treasury yields at the tail end of the third quarter, but gradually recovered once rates stabilized. Despite fluctuations caused by short-term rate movements, utilities had a solid quarter, outperforming the S&P 500 Index for the period and outperforming all other sectors in December’s sell-off. Periodic rate-induced volatility aside, utilities largely benefitted from being a “safe haven” sector in 2022, which helped drive relative outperformance. Utilities were the second best-performing sector of the market for the year after energy, and the only other sector to finish in positive territory.
Utilities saw a meaningful recovery in 2022. 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, utilities companies have continued to execute operationally and deliver strong earnings while also de-risking their portfolios. The gap in performance closed this year, and utilities have now outperformed the S&P 500 Index by more than 14% over the past 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 of 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 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) 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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