In This Article
RESILIENT ECONOMY WITH COOLING INFLATION
The U.S. economy is in better shape than anticipated when the year began. Robust employment has sustained a solid pace of consumer spending. Consumer confidence reflects near-term optimism despite a spate of high-profile layoffs, the highest interest rates in more than a decade, and reduced credit availability in the financial system. Conditions suggest that the slope of the economy’s slowing trajectory will remain shallow amid healthy employment trends.
Inflationary pressures, while still evident, will likely continue to moderate. We expect further increases in interest rates, though the bulk of the rate increases appear to be behind us for this cycle.
TECHNOLOGY EXTENDS ITS UPTURN
Trends in technology spending, which weakened earlier last year, have begun to stabilise. A combination of easing year-over-year comparisons and the priority of digital transformation, with an emerging impetus from artificial intelligence (AI), increasingly suggest a spending rebound and a return to longer-term investment trends moving toward year-end. The strong rebound in the prices of select technology shares on a year-to-date basis reflects both depressed valuation levels when the year began and early signs of upgrades to near- and medium-term revenue and profit forecasts among company managements, a trend we believe will gather pace in the coming quarters.
We expect to see generative AI use cases and applications spread from technology providers and developers to a wide variety companies that are eager to 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. There is a looming challenge in balancing the costs of these investments with business-model improvements and other priorities. While still very early, the sense of urgency could generate tangible results sooner and spur more spending than is currently discounted. Nevertheless, driven by 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 have been evident across the overall sector’s reported earnings this year.
Most style indexes posted gains in the second quarter, led by large-cap growth stocks. Growth outperformed value across capitalisations, with large caps outperforming mid and small caps. Small-cap value was the weakest market segment for the second consecutive quarter.
Longer term, 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 health care sector of the S&P 500® Index advanced 3.0%, trailing the overall Index’s 8.7% return. Additionally, the Nasdaq Biotechnology Index declined -1.0%. Over the trailing 12 months, the healthcare sector’s 5.2% return trailed the overall Index’s 19.5% gain.
It’s encouraging to see the post-pandemic recovery now apparent within the healthcare sector. Many industries are expected to realise above-historic-trend growth, particularly for drug reviews, drug approvals, and elective procedural growth. Additionally, as merger and acquisition activity has accelerated, Washington D.C. has become more amenable to approvals. Should economic uncertainty increase, the sector is less sensitive to the backdrop than others.
As we look toward the remainder of 2023, we believe that the sector will begin to show signs of leadership again as investors place more emphasis on stable company fundamentals and the significant alpha generating opportunity that broad innovation can provide. As a result, we think accelerating investment and innovation are not yet reflected in the price of many stocks.
The financials sector of the S&P 500® Index returned 5.3% for 2Q23 versus the 8.7% return of the S&P 500® Index. This positive return reflects the sector’s recovery from a difficult Q1 along with improving news on credit quality and balance sheet trends. All industry groups within the sector posted positive returns. Consumer finance and financial services did the best (reflecting “less bad” news on consumer trends).
Fallout from the first-quarter banking crisis was evident in continued deposit outflows at smaller institutions, though with a moderating trend following steps by the FDIC to fully guarantee deposits greater than the FDIC insurance limit of $250,000 at the failed institutions (Silicon Valley Bank, First Republic Bank, and Signature Bank). These actions calmed both depositors and investors, but without resolving the underlying issue of asset/liability mismatches on many balance sheets.
The sector’s focus continues to be directed toward liquidity and duration differences between a given bank’s assets (loans and 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 tech-driven efficiencies and generally better overall operation of businesses by management. Nevertheless, the market is less concerned with these dynamics and is solely focused on the expectation of a future economic slowdown and the course of Fed tightening.
Despite lagging the return of the S&P 500® Index during the second quarter, midstream energy gained ground again. Recessionary fears continued to weigh on the broader energy sector - as well as on crude prices despite OPEC’s best efforts to support the commodity - while natural gas finally saw some stability after two quarters of plummeting prices. While energy was one of the worst-performing sectors during the quarter and finished the period with a very slight negative return, midstream’s gain was solid. The sub-group has been the best-performing segment within the energy sector, both on a quarterly and year-to-date basis. For the full three-month period, the Alerian MLP Index gained 5.3%, but underperformed the S&P 500® Index by 340bps.
While some of 2022’s strong tailwinds have dissipated and macro uncertainties persist (weighing on energy broadly year-to-date), the midstream segment has bucked the broader trend. The group is well-positioned both near- and long-term, generating above-average cash flow yields while trading at a significant valuation discount to the broader market. 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 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 for the commodities and, more importantly to midstream infrastructure, the essential logistical systems that move them. Midstream energy infrastructure companies have difficult-to-replicate asset networks with high barriers to entry and adaptability to transport other energy sources that 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.
Volatility in bond yields and falling power prices weighed on utilities during the quarter. It was another tough quarter for utilities as the market’s attention was captured by growth sectors at the expense of defensives and cyclicals. The group, as measured by the S&P 500 utilities sector (“utilities”), was the worst-performing sector of the market, underperforming the S&P 500® Index by over 1100bps. Apart from energy, it was the only sector to lose ground during the quarter. Utilities did relatively well in April as concerns about bank failure contagion still lingered, as well as sporadically throughout the quarter when recessionary fears spiked. But the sector lagged when the market turned its focus back to growth as concerns abated deeper into the quarter. Utilities finished 2Q23 down 2.5% versus the +8.7% return of the S&P 500® Index.
Despite a meaningful recovery in relative performance in 2022, the excess return gap to the broader market has largely closed this year. While fundamentals have remained strong, the group’s relative performance has struggled the last few years and, except for 2022, the utilities sector has been one of the weakest. However, even during the economic volatility of the past few years, companies within the sector 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 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.
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The views expressed herein are of Jennison Associates as of July 2023 and 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 as an offer to sell or a solicitation to buy any securities mentioned herein. Any projections or forecasts presented herein are subject to change. This commentary does not purport to provide any legal, tax or accounting advice. 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.
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