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 favourably 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.
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 favour 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.
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 utilisation 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 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. Future income statement pressure will come from continued labour 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 centre, 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 normalised 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 revolutionise 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.
References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in the portfolio at the time of publication and, if such securities are held, no representation is being made that such securities will continue to be held.
The views expressed herein are those of PGIM investment professionals at the time the comments were made, may not be reflective of their current opinions, and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. Neither PFI, its affiliates, nor their licensed sales professionals render tax or legal advice. Clients should consult with their attorney, accountant, and/or tax professional for advice concerning their particular situation. 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.
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