A Boom Cycle for Growth Stocks
Apr 30, 2024
In its 2Q24 Outlook, Jennison Associates feels optimistic about the economic resiliency and secular trends that may bring significant growth in the coming years.
STRONG BUT SLOWING GROWTH AHEAD
Equities have had a fast start in 2024, particularly with the further appreciation of growth equities in the quarter. We can trace these returns to broader themes that have been at play for the past several quarters, namely enthusiasm for generative artificial intelligence (AI) and the ongoing growth of GLP-1 drugs for weight loss related to diabetes treatment.
Economic activity and associated service-related inflation measures in the first quarter came in at higher levels than broadly forecast at the start of the year, leading to a reduction in the expected pace and scope of reductions in the federal funds rate at the end of the first quarter. While macroeconomic variables do not drive our investment process, they do shape investor expectations and behaviour. The narrative around a slowing economy and the possibility of outright recession have waxed and waned over the past year, with investors attempting to gauge the impacts of the Fed tightening cycle that started in 2022. History suggests these impacts lag actual activity levels by as much as 18 months to two years. Given this historical context, fewer now expect a recession, which partly speaks to the changed interest rate landscape since the year began.
Abundant liquidity, a banking system that has withstood significant stress following last year’s high-profile failures, and continued favourable employment-market dynamics point to an environment of stronger U.S. economic growth, though at lower levels than in the previous few years. The nature of our conversations with the managements of the companies that we cover are reflective of this outlook. Earnings growth should drive investment results over a three-year investment time horizon while we remain keenly focused, as ever, on discovering new opportunities.
SECTOR VIEWS
The market environment in the first quarter of 2024 reflected similar trends that closed out 2023, with investor sentiment and company fundamentals trending positively. Equities gained despite a pushback in the timing and magnitude of expected cuts in the U.S. federal funds rate. We believe the market will continue to favour 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 a strong 2023, the S&P 500® Index’s information technology sector was up 12.7% in the first quarter of 2024. This reflects continued 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). Additionally, we are seeing ongoing improvement in the forward discounting mechanism for long-duration equities.
As a reminder, calendar year 2022 produced multiple compression and lowered earnings revisions across the entire sector. By December 2022, 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 declining. Nevertheless, driven by disruptive opportunity for AI and the digital transformation of the consumer and businesses, 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 continues 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. We would 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 healthcare sector of the S&P 500 Index advanced 8.9%, trailing the overall Index’s 10.6% return. Additionally, the Nasdaq Biotechnology Index advanced 1.6%. Over the trailing 12 months, the healthcare sector’s 16.1% return trailed the overall S&P 500 Index’s 29.9% gain.
We believe the current setup for the sector is extremely favourable. Healthcare is one of few sectors that offers access to open-ended total addressable markets. Presently, the combination of several drugs/therapies in both late stage and pre-commercialisation in large markets, e.g., obesity, asthma, cholesterol, COPD, multiple sclerosis, and lupus, coupled with a broad recovery in utilisation, offers an attractive runway for sustainable growth. We favour companies that provide a significant benefit to the patient, improving the human condition and thus offering the highest rate of return to the healthcare system, which in turn garners the highest and most sustainable level of reimbursement from the various payees across the globe.
Looking ahead, there are several potential catalysts for the sector given therapeutic advancements and drug launches. We believe that procedural volumes will continue to recover as the last vestiges of COVID-related headwinds abate and the broad system returns to its normal rhythm. Certain areas of medical devices should experience above historical market growth in 2024 as nurse shortages end and hospitals look to accelerate profitable growth.
The financials sector of the S&P 500 Index returned 12.5% for 1Q24 versus the 10.6% return of the S&P 500 Index. The sector was led by consumer finance, insurance, banks, and financial services — all up between 12%-18%. Mortgage REITs was the only industry that posted negative returns at -1.2%.
We continue to see improving news on credit quality and balance sheet trends. The slowing pace of the Fed’s policy adjustment was a positive contributor. Commentary from Fed board members in the past three months emphasised 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.
Overall, the large money centre, consumer finance, and super-regional banks are better positioned today than they were in the 2008-2009 financial crisis across a broad range of balance sheet, capital, and risk management metrics. Secular growth companies with defensive attributes (low leverage rates, asset-light models, sustainable, high margin, and high-free-cash-flow businesses) should perform better. Several digital payments and financial technology companies meet these criteria.
After lagging growth sectors for most of last year, the energy sector was one of the best-performing groups in the first quarter, outperforming the broader market. Midstream energy continued to advance as the Alerian MLP Index (AMZ) gained 13.8% and outpaced the S&P 500 Index. The more diversified Alerian Midstream Energy Index (AMNA) advanced 10.1%. While oil prices rebounded, natural gas continued to be weak but midstream performance was largely unscathed. WTI crude rose 16.1% and Henry Hub natural gas fell 29.9%.
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 in the 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. 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 gained 4.6% in 1Q24 versus the 10.6% return of the S&P 500 Index. The recent rising-interest-rate environment weighed heavily on the group, but the pullback in the 10-year Treasury, end of Fed tightening, and potential for rate cuts brought some relief to the utilities sector that continues in 2024. Defensives and cyclicals performed better on a relative basis in 1Q24 as sector market participation broadened out. Regulatory concerns have tempered the outlook for this year somewhat, but the potential effect of generative AI on power demand growth and utility earnings have increased investor interest in the sector.
Improving economics in wind and solar power continue to remain a growth driver for the overall sector; companies are only now beginning to incorporate renewables into their capex plans, allowing them to earn a regulated rate of return on their renewable investments. Utilities are by nature a defensive sector, and those companies with regulated or quasi regulated (renewables) businesses generate long-duration cash flows and predictable rate base earnings. In addition to providing stable dividends even in periods of uncertainty, growth in renewables should help drive earnings above the sector’s historical 3%-5% growth rate.
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