Examining growth prospects & inflation concerns
In this podcast, Guillermo Felices, Principal and Global Investment Strategist at PGIM Fixed Income examines growth prospects & inflation concerns.
Investors are facing a complex landscape heading into year-end. Interest rates are responding to elevated wage and goods price inflation, exacerbated by supply-chain bottlenecks and shortages of critical components. While the direct disbursement of fiscal stimulus is winding down, liquidity remains abundant, sustaining high levels of demand and contributing to inflationary pressures. GDP growth expectations have moderated in recognition of these supply constraints, although growth should continue to outpace pre-pandemic levels in the short term. We expect corporate profit growth to return to pre-COVID-19 trend levels over the course of next year. While these levels are respectable in absolute terms, they represent a meaningful slowdown from the COVID-driven highs reached over the past 18 months.
Many companies that reported strong operating results during the pandemic, due to the shift to online shopping and work-from-home business models, are facing challenging year-over-year financial comparisons. While this may be a headwind to share prices in the short term, we believe the developments of the past 18 months have accelerated trends in consumer and enterprise behavior that were already in place prior to the arrival of COVID-19 and that the step-up in growth in these areas will persist for some time.
Elsewhere in the market, the cyclical companies hit hardest by the shutdowns of 2020 appeared poised for a significant recovery in operating performance earlier in 2021, as the economy reopened. However, the emergence of the delta variant, supply-chain issues, and labor shortages have resulted in an uneven recovery in their financial performance and clouded the outlook for revenue and margin improvement.
We remain optimistic that innovative secular growth companies are well positioned to navigate this complex landscape. While these companies are not insulated from the macro backdrop, we believe ones with market-leading positions, strong cash-flow generation and reinvestment, and often-disruptive business models can deliver growth that is higher and lasts longer than the market currently expects—leading to share price outperformance over a longer-term investment horizon.
We are often asked if this favorable outlook is already reflected in growth stock valuations, particularly following strong absolute performance over the past few years. Today’s valuations reflect many factors, including low interest rates and above-average long-term growth expectations. However, we believe they do not adequately discount our expectations for above-consensus growth over the longer term, especially for companies with exciting long-term prospects but high re-investment rates. Therefore, we do not utilize current profits as a basis of our valuation methodology for these types of companies. We acknowledge the higher risk associated with such companies, but we believe the risk is mitigated by a deep understanding of their fundamentals and the outsized returns these companies can generate, if execution against ambitious targets can be achieved.
In the third quarter, financials was the best-performing sector followed by utilities and information technology. Material and energy lagged. For the trailing one-year period, energy led market returns. Financials, communication services, information technology, industrials, and materials also performed well. Defensive sectors like consumer staples and utilities underperformed. Information technology and consumer discretionary maintain their leadership positions for the three-, five-, and trailing ten-year periods.
In 2021’s third quarter, the health care sector of the S&P 500 Index rose 1.5%, outperforming the overall Index’s advance of 0.5%. Despite near-term challenges from macro forces and sentiment trading around the virus, health care is one of the fastest-growing sectors in the global economy. 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 health care is switching to more preventive medicine and an outcome-based economic model. This backdrop presents unique opportunities to allocate capital to multiple health care industries. Recent developments out of the FDA, a benign regulatory environment out of Washington D.C., and increased government support for bioresearch in the U.S. and elsewhere, coupled with improved protocols around COVID-19, make us excited about the sector’s future growth potential.
Financials returned 2.6% for 3Q21, outperforming the 0.5% return of the S&P 500 Index. While mitigated somewhat by concerns about the rise of the delta variant, the earnings recovery continues to move forward. 3Q21 tailwinds for the sector have been primarily driven by the vaccine rollout, continued (but non-linear) strength in the economic recovery coinciding with the reopening, better credit conditions, relatively higher interest rates, and the lingering effects of the second stimulus. The current backdrop remains favorable for universal banks and brokers/asset managers as the capital markets are robust and expenses well-controlled. Scale has become a competitive advantage, and we are positive on business models with a broad reach along with higher profitability metrics. Also, higher interest rates (especially with a steeper yield curve) translate into higher interest revenue and earnings for the regional banks, though this is largely priced into those stocks.
In the third quarter, the Alerian MLP Index lost 5.7%, while the Alerian Midstream Energy Index, which includes a broader group of midstream infrastructure companies as well as MLPs, fell 2.8%. Weakness earlier in the quarter was mitigated to a large extent by a strong rally in energy in the last month following solid earnings, strong commodity prices, and signs the delta variant may be peaking. Improved fundamentals are finally starting to be reflected in stock prices but may give investors pause given uncertainty in the exact timing of a full reopening of the U.S. and global economies. As economic activity continues to slowly ramp up, stocks should begin to price in not only the short-term economic recovery bounce, but also the long-term positive benefits from the significant transformational corporate reform that has occurred over the past few years. 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 the commodities but for the essential logistical systems that move them. With physical steel in the ground, midstream infrastructure companies have difficult-to-replicate asset networks with high barriers to entry and their 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 finished 3Q21 up 1.5%, modestly outperforming the S&P 500’s return of 0.5%. Utilities has been the worst-performing sector over the past 12-month period, despite strong underlying fundamentals. We continue to find the sector attractive given the still lower-than-average interest rate environment, the sector’s predictable fundamentals, and its ability to provide stable dividends amidst macro uncertainty. We believe it should also provide earnings growth above its historical 3-5% EPS growth, given the potential growth opportunities from renewable energy investments.
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) health care 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.
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