We examine the current macro backdrop and where investors can potentially find pockets of growth.
- Easy returns and accommodative central banks appear to be emphatically behind us, and we now find ourselves in an environment where we believe true, differentiated research, robust single-security analysis and hard work will be critical.
- We believe the current market backdrop should create opportunities for true active management with a focus on traditional stock-picking.
- From our perspective, certain areas of health care, industrials and energy could potentially offer investors some relative comfort in the current uncertain macro environment.
2022 was a challenging year for global equities as central banks, led by the Federal Reserve (Fed), pivoted from accommodative monetary policy to perhaps the most aggressive monetary-policy tightening in history to curb inflationary pressures. Inflation has been exacerbated by Russia’s invasion of Ukraine, while US/China tensions have simmered in the background, with potential long-term implications for manufacturing, particularly in industries like technology and semiconductors.
The primary driver of equity-market declines during 2022 was earnings multiple contraction, which is symptomatic of tighter global liquidity. Still, aggregate corporate earnings have held up better than expected, largely since nominal growth has remained firm.
Looking to 2023, some investors and commentators maintain a bullish outlook, believing that slowing inflation could allow central banks to decelerate or even pause the tightening of monetary policy, which could bring an end to the multiple compression; the Fed has already scaled back the pace of interest-rate hikes in December. Meanwhile, global spending on technology as a percentage of GDP is likely to increase as companies strive to remain competitive, as evidenced by the passage of the CHIPS and Science Act by Congress to incentivize onshoring of key technologies.
There are also signs that China’s policy is changing, with the stepping up of support for the property sector and the easing of the controversial zero-Covid policy. Building on this, if we were to see a mild winter in Europe and a de-escalation of the situation in Ukraine, sentiment would be likely to improve further. Such a bullish scenario cannot be discounted. However, leading indicators of global nominal growth point toward a continued slowdown into 2023, serving as a headwind to aggregate earnings and suggesting earnings will be the challenge for the equity market in 2023.
In short, we believe investors are entering a new paradigm. The days of easy returns and accommodative central banks appear to be emphatically behind us, and we now find ourselves in an environment where we believe true, differentiated research, robust single-security analysis and hard work will be critical.
An Uncertain Backdrop
Throughout 2022, the Fed aggressively moved to staunch soaring inflation, creating a domino effect that has driven equity and bond markets down considerably. The meteoric rise in interest rates has affected access to capital and the cost of capital, with the intention of slowing economic activity, and importantly, cooling the overheated real-estate market.
Predicting Fed Chair Jerome Powell’s future intentions could prove to be a fool’s errand, as the lengths he must go to in order to curb inflation may be unknown to him at this point. However, he is making sure that investors understand the Fed’s focus on inflation and has signaled that the central bank will continue its quantitative-tightening measures until its desired goal is achieved. Powell’s power of the podium is another tool at the Fed’s disposal as he uses his messaging to influence investors and corporate leaders around the world, entreating them to help the Fed gain control of inflation.
As the Fed continues this quest to curb inflation, its policies have stoked fears of recession and its impact on corporate earnings. Thus far, earnings have proven to be resilient, but the extent to which they will fall in 2023 and beyond is unclear, with the range of outcomes appearing very wide. Currently, the consumer is proving to be resilient as the job market remains robust. However, the true test will be whether the Fed can continue its work to tame inflation without destroying the employment market. This could be difficult to achieve as higher interest rates typically create a snowball effect, leading to slowing spending, which then ripples its way throughout the economy, ultimately dragging down earnings. In reality, the true effect of the Fed’s tightening is lagged and not felt in real time. We believe we have not yet begun to feel the full effects of these hikes.
What Can Investors Do?
In a decelerating global economy, where can investors look for possible returns? We have seen more than a decade of accommodative Fed behavior, which has enabled investors to be successful through a ‘buy and hold’ approach by which they could simply purchase and retain certain securities, feeling confident that their value would increase over time. This period was particularly favorable, especially for equity investors. However, the investment landscape has fundamentally changed, with the Fed now battling an inflationary environment.
While inflation may not stay so elevated over the long term, it is likely that it will remain persistently higher than the benign state we have seen for the last decade. We believe this requires investors to employ more of a trading approach to the market, using short-term sell-offs as opportunities to add risk, and short-term moves up as an opportunity to remove risk, as opposed to buying and holding securities through thick and thin. This should create opportunities for true active management with a focus on traditional stock-picking and dampen some structural support for large-cap companies.
We think an environment with structurally higher rates and inflation is far more likely to favor value rather than growth stocks. However, the relative pain for growth may already be in the rearview mirror. The valuation reset for high-growth names has been fast and indiscriminate over the year, and most areas of growth are justifiably trading at or near ten-year lows.
Additionally, current environmental and geopolitical headwinds are leading to trends of deglobalization, regionalization and localization, which are causing companies across the globe to rethink their supply chains and reinvent how – and where – they manufacture products. Such efficiencies can enable companies to be ‘lean and mean,’ better controlling both local inventories and distribution. We believe companies that enable this localization, as well as companies that benefit from it, could provide attractive opportunities for investors. Furthermore, this move toward localization should be a catalyst that allows certain small-cap companies to outshine their large-cap counterparts.
Against this backdrop, single-security analysis and identifying business that can navigate this very challenging macro environment, including supply-chain and inflationary issues, are likely to be key for investors.
Pockets of Growth
With an uncertain macro backdrop, it is important for investors to look for areas of the market that can potentially offer some relative comfort. One area we are particularly excited about is health-care innovation. There are many elements of health care that we believe could see multiple decades of progress condensed into just the next few years. New forms of health-care delivery, whether it is telehealth or better primary care offerings, are expected to become much more robust. Holding the health-care system more accountable for outcomes and costs could become another key trend.
In technology, areas such as digital transformation, a more frictionless economy (providing better experiences for consumers through automation), and cloud computing remain in relatively early stages of development, allowing room for further potential growth. Companies that differentiate and distance themselves through unique intellectual property or business models, and which have assembled impressive innovation and go-to-market engines, are likely to have greater opportunity to achieve important scale in their core businesses, which could enable them to dominate the landscape. Many of these opportunities, such as CPaaS (communications platform as a service), are still in the early stages of harnessing new use cases, and we believe that this could help first movers and true innovators achieve long-term growth targets.
But it isn’t all about health care and technology. Industrials and materials companies engaged in the transformation of materials, substances or components into new products are driving innovation around areas such as energy transition, infrastructure and the move to electric vehicles. Finally, the energy sector also appears attractive as the severe energy supply crisis takes hold of Europe and the world more broadly. Many energy companies are employing new business strategies as they focus on capital discipline, returns, and returning cash to shareholders. Energy has also proven to be a very under-owned sector despite showing robust performance over the last 12 to 18 months.
Positioning for Better Outcomes
As investors face challenges such as steadily declining global growth and a shifting geopolitical landscape, we believe that a holistic approach can provide a roadmap to finding potential opportunities. In particular, our analysts and portfolio managers exploit our multidimensional research capabilities, which include innovative areas, from investigative research by former journalists, to specialist insights on ESG (environmental, social and governance) issues, and expert analysis of private markets. We believe these multi-faceted capabilities, working together, can successfully prepare us to navigate the global challenges investors face as we seek to deliver better outcomes for our clients.
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