Secular Themes to Weather a Slowdown
Jan 23, 2024
In the 1Q24 Outlook, Jennison Associates sees a slower but still resilient economy and highlights secular opportunities to help navigate a slowdown.
A SLOWING ECONOMY WITH TAILWINDS FOR GROWTH
The continued volatility in capital markets reflected economic and geopolitical realities in different ways throughout 2023. The grudging pace of the U.S. economic slowdown might be the biggest surprise of the year. Consumer resiliency in the face of geopolitical and macroeconomic turbulence is the primary reason, reflecting low unemployment, balance sheet strength, and rising financial asset prices. Uncertainty about the U.S. economy’s ability to avoid recession remains a focus entering 2024. We believe the evidence suggests slowing growth but not outright recession ahead. The easing pace of inflation, along with lower borrowing costs, are new tailwinds to activity. Wage rates, one of the last contrary indicators, are no longer rising and, in some cases, entry level pay is now below the pandemic peak. Finally, corporate profits broadly have favorably weathered the post-pandemic period despite the demand pull forward and supply chain disruptions.
The last two plus years encompassed financial market distress driven by historic inflationary pressures and interest rate increases, followed by a rebound in asset prices to levels that, in some cases, reached near peaks. Valuation has played a significant role in both the decline and rebound of asset prices. This period has been challenging, but many secular growth companies have meaningfully participated in the recovery. These companies have navigated throughout the environment in strong financial and operational health.
SECTOR VIEWS
The equity markets rallied in the fourth quarter as expectations for further rate hikes declined and the potential for rate cuts in 2024 began to emerge. Continued vigorous rallies across the capital markets followed the announcement. 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.
After some give-back in the third quarter, the S&P 500 Index’s information technology sector was up 17.2% in the fourth quarter of 2023. The sector finished the year up 57.8%, an impressive recovery from a disappointing 2022. This reflects both better-than-expected fundamentals across a broad range of business models, along with an improving macro environment (primarily inflation coming down sharply and the consumer holding up well). This has translated to less uncertainty surrounding the forward-discounting mechanism for long-duration equities.
Calendar year 2022 produced multiple compression and lowered earnings revisions across the entire sector. Forward consensus on near-term fundamentals and growth trajectories had been reset lower in anticipation of further deterioration of the macro environment, with P/E multiples coming down too. Nevertheless, driven by disruptive opportunity for artificial intelligence (AI) and the digital transformation of the consumer and businesses, the longer-term underlying strength in these business models and their secular revenue trends remain solid and were highlighted across the overall sector’s reported earnings in 2023.
We expect to see generative 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.
We believe that the continued ramping-up of data/information/entertainment usage across a broad range of devices and applications, along with digital payments, are among the areas that offer long-duration opportunities and huge addressable markets for companies with the right technologies. Business and consumer behaviors have clearly changed, with adoption and uptake rates inflecting higher.
The healthcare sector of the S&P 500 Index advanced 6.4% in the fourth quarter, trailing the overall S&P 500 Index’s return of 11.7%. Additionally, the Nasdaq Biotechnology Index advanced 10.7%. Over the trailing 12-months, the healthcare sector’s 1.9% return trailed the overall S&P 500 Index’s 26.2% gain.
Innovation and spending across drug development, genetic sequencing, data collection and healthcare service delivery is accelerating and has continued to increase post-COVID. The U.S. market alone is approximately $4 trillion and growing at a rapid pace. We’ve seen an unprecedented level of development aimed at some of the world’s largest total addressable markets, including diabetes, obesity, cardiovascular disease, and cancer.
Healthcare utilization and procedures have risen post-COVID, with an acceleration over the past 12 months. An aging population, more engaged consumers and advancements in tech-enabled procedures and devices should support further upside over the long term.
M&A activity has notably improved both in terms of count and dollar size. Based on the current run rate for the year, 2023 is on pace to be one of the strongest M&A years in over a decade. We believe the uptick in M&A activity is sustainable as cash-rich, larger-cap biopharma companies continue to look to replace the greater than $200 billion loss in revenues from commercial drugs that are scheduled to come off patent in the coming years.
The financials sector of the S&P 500 Index returned 14.0% for 4Q23 vs. the 11.7% return of the S&P 500 Index. All industry groups within the sector had solid positive returns, led by consumer finance, banks, and capital markets—all up between 19-28%. The other three industry groups (financial services, insurance, and mortgage REITs) all finished up 7-9%. For the full year 2023, the financials sector of the S&P 500 finished up 12.1% vs. the S&P 500 at 26.3%.
We continue to see improving news on credit quality and balance sheet trends. The slowing pace of the Fed’s monetary policy adjustment was a positive contributor. Commentary from Fed board members in the past three months emphasized the need to remain vigilant in the ongoing process of fighting inflation. At the same time, they acknowledged the diminishing pace of gain in the headline inflation rate year-over-year, coupled with the lagging impacts of the rate increases of the past 12 months that have yet to fully reveal themselves.
The sector’s focus continues to be directed toward liquidity and duration differences between a given bank’s assets (loans, securities) and liabilities (deposits and term funding). In addition to liquidity, we believe another key risk to banking health is the status of loan quality. Banks carry significant exposure to commercial real estate (CRE), which is experiencing significant secular (post-COVID) and cyclical challenges. As this economic cycle potentially turns, asset quality will need to be watched closely. Future income statement pressure will come from continued labor cost pressures, but this is being offset by improved tech-driven efficiencies and generally better overall operation of the businesses by management.
Overall, the large money center, consumer finance, and super-regional banks are significantly better positioned today than they were in the 2008-2009 financial crisis across a broad range of balance sheet, capital, and risk management metrics. As a return to normalized growth plays out over the long term, secular growth companies with defensive attributes (low leverage rates, asset-light models, sustainable, high margin, and high free cash flow businesses) should fare better. Several digital payment and financial technology companies meet these criteria.
Midstream energy advanced again in the fourth quarter of 2023, outperforming all other energy sub-sectors but lagging the S&P 500 Index. After a strong 3Q, the energy sector gave back gains at the end of the year and was the worst-performing sector of the market throughout 4Q. Despite solid demand, oil prices fell steadily during the period as production disagreements within OPEC exacerbated what was already a deteriorating supply outlook. WTI crude fell 21.0% and Henry Hub natural gas was weak as well, falling 14.2%. Despite lagging the broader market, midstream was once again the best-performing energy sub-sector during 4Q and, along with the refiners, the only segment to advance. For the full 3-month period, the Alerian MLP Index (AMZ) gained 5.0%, while the Alerian Midstream Energy Index (AMNA) advanced 6.4%, both lagging the 11.7% return of the S&P 500 Index.
Some of 2022’s strong tailwinds dissipated in the first half of the year and macro uncertainties weighed on energy broadly, but the midstream segment bucked the broader trend. In fact, midstream was the leader within energy for 2023. Driven by above-average cash flow yields and volume growth yet trading at a significant valuation discount to the broader market, the group remains well-positioned both near- and long-term. We think this disconnect presents an opportunity given the significant transformation in the sector over the last few years. We believe the capital discipline shown by management teams will continue, the sector will remain free cash flow positive, and companies will continue to return capital to shareholders. Earnings results have been strong and share buybacks continue to provide stock valuation support.
Over the longer term, midstream energy companies will 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.
The utilities sector of the S&P 500 Index gained 8.6% in 4Q23 versus the 11.7% return of the S&P 500 Index. While the sector continued to underperform the broader market, utilities finally advanced in 4Q23 after three straight quarterly losses. Rising interest rates weighed on the group throughout the year, but the pullback in the 10-year Treasury and an eye toward the end of Fed tightening finally brought some relief to the utilities sector in the fourth quarter.
Despite a meaningful recovery in 2022, the utilities sector had its worst relative performance in over 40 years in 2023. While fundamentals have remained strong, the group’s performance versus the broader market has struggled over the past five years and the utilities sector has been one of the weakest. However, even during the economic volatility of the past few years, utility 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, continued recessionary concerns and a flattening yield curve remain tailwinds. Strong fundamentals and macro factors underscore the opportunity in the sector, especially given what remains a lower-than-average interest rate environment by historical standards (even when considering the recent uptick in rates).
SECULAR THEMES FOR 2024 AND BEYOND
As the global investment landscape continues to evolve, our focus on finding innovative companies naturally uncovers disruptive themes over time. Below are secular themes we see offering compelling growth opportunities based on our bottom-up research.
- Advanced Technologies: AI and cloud computing continue to revolutionize industries, amplifying demand for increasingly intelligent software and infrastructure.
- Industrial Automation: A boom in manufacturing and high-tech facilities leveraging AI is driving revolutionary automation of industrial processes to enhance efficiencies.
- Healthcare Innovation: An innovation cycle marked by advanced research capabilities, game-changing therapies, and digital supply chains is fostering demand for more integrated healthcare ecosystems.
- Global Consumer: Large, younger demographic populations with healthy disposable incomes are reshaping consumption patterns and generating persistent demand for luxury goods.
- Fintech Platforms: Emerging market consumers are rapidly embracing powerful financial technology platforms, particularly where there are few sophisticated financial systems.
- Transformative Mobility: Evolving structural trends in electric vehicles, autonomy, and mobility-on-demand are creating new mobility ecosystems to get people and goods from point A to B more efficiently.
For financial professional use only. Not for use with the public.
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.
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 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.
Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. The manager has no obligation to update any or all such information, nor do we make any express or implied warranties or representations as to the completeness or accuracy. Any projections or opinions presented herein are subject to change without notice. Actual data will vary and may not be reflected here. Projections and opinions are subject to high levels of uncertainty. Accordingly, any projections or opinions should be viewed as merely representative of a broad range of possible outcomes. Projections or opinions are estimated, based on assumptions, subject to significant revision, and may change materially as economic and market conditions change.
This material is being provided for informational or educational purposes only and does not take into account the investment objectives or financial situation of any client or prospective clients. The information is not intended as investment advice and is not a recommendation. Clients seeking information regarding their particular investment needs should contact their financial professional.
Investment products are distributed by Prudential Investment Management Services LLC, member FINRA and SIPC. PGIM Investments is a registered investment advisor and investment manager to all PGIM U.S. open-end investment companies. PGIM Quantitative Solutions, Jennison Associates and PGIM are registered investment advisors and Prudential Financial companies. PGIM Quantitative Solutions is the primary business name of PGIM Quantitative Solutions LLC, a wholly owned subsidiary of PGIM. PGIM Fixed Income and PGIM Real Estate are units of PGIM.
© 2024 Prudential Financial, Inc. and its related entities. PGIM Custom Harvest, Jennison Associates, Jennison, PGIM Real Estate, PGIM and the PGIM logo are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide.
For compliance use only 1077151-00001-00