Investing Through Shifting Macro Perspectives - SG
PGIM asset managers share perspectives on the evolving investment landscape and provide insights on key trends to shape 2023 and beyond.
Growth Stocks to Rebound Amid a Slowdown
Jul 13, 2022
Jennison Associates’ 3Q22 Outlook explains why durable growth stocks are attractive in a slowdown and highlights attributes for relatively resilient companies
HIGHLIGHTS
- High-quality growth companies provide relative resiliency during periods of slowing growth. We look for companies able to withstand the slowdown through innovation and agility. These companies’ strong balance sheets and financial flexibility should allow them to gain market share and continue to invest for future growth.
- In Technology, large, global-oriented total addressable markets driven by demographic and adoption trends provide an ample runway for long-duration growth.
- The convergence of technology and consumerization is fueling innovation in Healthcare as the sector switches to more preventive medicine and an outcome-based economic model.
- Financials could be negatively impacted by potential falling confidence and eroding credit conditions, although bright spots remain in banks and property and casualty insurance.
- Utilities represents a compelling defensive growth proposition for investors, underscored by strong fundamentals and macro tailwinds. Improving economics in renewables should help drive the sector’s earnings going forward.
HIGH UNCERTAINTY AND LOWER GROWTH LIE AHEAD
Over the past year, the investment backdrop has transformed from one of stimulus and spending to one of inflation and tightening financial conditions, with the battle to control inflation moving aggressively to the fore. Investors remain concerned around the Fed’s willingness to take the measures necessary to combat historically high inflation, despite the recently stepped-up magnitude and pace of rate increases and language communicating a “whatever it takes” approach to the problem.
The uncomfortable truth for policymakers is that the primary sources of elevated headline inflation this year are supply driven—tied directly to the conflict in Ukraine and the related Russia sanctions—which challenges the effectiveness of monetary policy as a tool for addressing the problem. Meanwhile, an intensifying slowdown in activity around the globe and rising concerns over recession in many economies will confront investors and policymakers as the second half of the year unfolds. In that vein, the Fed’s task of bringing inflation back to its 2% target without undermining the robust employment backdrop and precipitating a recession underscores current uncertainty around the macro outlook.
In our view, we are not yet at the point where a U.S. recession is an inevitable outcome, but the prospects for one continue to build in Europe. Coincidentally, companies are approaching their planning with the recognition that the intermediate-term outlook poses greater uncertainty today than it did when the year began. Adjustments in hiring plans and greater impact from foreign currency translation on reported profits are among the shifts that are impacting full-year financial outlooks at this stage.
DURABLE GROWTH STOCKS ARE MORE ATTRACTIVE IN A SLOWDOWN
The advantages and attributes of high-quality growth companies tend to attract greater attention from investors during slowing periods, given their relative resiliency to economic headwinds. For much of the past 40 years, disinflation was the common theme, and interest rates trended lower, particularly during economic slowdowns.
In the current cycle, however, a spike in inflation has forced policymakers and the market to respond with sharply higher interest rates, pushing up the discount rate investors apply to the value of future cash flows for many growth companies. As a result, the overall valuations of these stocks have adjusted significantly to this impact over the past several months, returning to pre-pandemic levels.
We believe companies best placed to withstand the slowdown have unique products and services that address demands in growing markets through innovation and agility. They have strong balance sheets and financial flexibility, which should allow them to gain market share from weaker competitors, while continuing to invest for future growth throughout the period.
SECTOR VIEWS
Value continued to outperform Growth across all market-cap segments during the second quarter. Along with energy, defensive sectors such as consumer staples, utilities, and health care held up better during the quarter. Growth sectors like consumer discretionary, communication services, and information technology were the weakest.
But over the long term, we believe the market should continue to favor growth companies with asset-light business models, 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 economic environment is expected to slow back to its post global financial crisis average.
The S&P 500 Index’s information technology sector was down -20.2% in the second quarter of 2022 and was one of the worst performing sectors in the broader market S&P 500, which was down -16.1% in the quarter. The quarter was a continuation of the give-back trend we’ve seen since November 2021 from especially strong technology results the previous two+ years.
The short-term difficult macro environment, along with negative global economic sentiment through 2023, continued to drive stock prices. As a result, performance in the quarter was driven by multiple compressions and the ongoing normalization of earnings to pre-COVID levels, especially for technology. This has also led to the lowering of forward guidance into 2023 for many companies in the secular growth basket, thus compounding the situation for these stocks. It does not look like the current environment is expected to change in the short run (risk levels will remain elevated), so on a go-forward basis we can expect continued volatility and consolidation for the technology sector, both relative and absolute.
Nevertheless, the longer-term underlying strength in these business models and their secular trends remain solid. This is reflected in the industry results within the sector, where areas that have some of the highest levels of long-duration earnings growth (IT services, software, and semiconductors) had the largest negative performance.
We also see continued acceleration and long-duration technology demand from the large global millennial population, given their early uptake of so many digital economy related products (many of which are driven through the smartphone) that are solving their real-world problems. We believe these large, global-oriented total addressable markets provide an ample runway for long-duration top- and bottom-line growth, with many disruptive trends expected to double over the next three to five years. Historically, earlier stages of mass adoption have spurred more innovation, greater ease of use, and an expansion of the ecosystem, which in turn has kept the virtuous cycle spinning with yet greater adoption. We believe the tech transformation that accelerated during COVID-19 was simply the beginning of a multi-year trend.
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.
As we move further into 2022, it is our view that the impact from COVID, coupled with many headwinds the sector faced in 2021, are 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 and long term positive for the sector, in particular, biotech. We are pleased to see that the most negative elements of drug pricing reform are now off the table and expect the final details of any reform to be manageable.
Healthcare is one of the fastest growing sectors in the global economy which is driving rapid scientific and technological advancements. The convergence of technology and consumerization is fueling an unprecedented flow of innovation to address unmet medical needs and reduce costs. This evolution will have a lasting impact on the patient experience as Healthcare is switching to more preventive medicine and an outcome-based economic model. This backdrop presents unique opportunities to allocate capital to multiple healthcare industries.
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.
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.
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