How will quality behave in 2022?
An article we wrote early last year highlighted that the risk of inflation and higher interest rates could be a catalyst to refocus attention on business fundamentals and support our investment strategy of “quality at a reasonable price”.
At the time of writing, we had seen a short-term rotation of the market into some of the deepest value and cyclical segments of the market, as well as a continued exuberance of many unprofitable thematic and growth stocks, which had contributed to short-term growth. long-term underperformance of our strategies relative to our benchmark. As the year progressed, we saw the market sentiment shift back to rewarding underlying business fundamentals and as a result, each of our global equity strategies performed strongly in 2021.
As inflation and interest rate expectations have continued to evolve over the past 12 months, we thought it worth providing an update on the current market environment. , as well as why we continue to believe that our “quality at a reasonable price” approach to investing remains well positioned to outperform.
Inflation has so far proved stronger and more persistent than many expected at the start of 2021.
The February 2022 U.S. CPI rose 7.9% from a year earlier, the fastest pace since 1982. The U.S. core CPI (which excludes food and energy) rose 6 .4%, the largest increase since 1982.
It’s a similar story in other parts of the world, including the UK where annual inflation hit 6.2% in February, the highest rate in 30 years, and the eurozone where the inflation hit a record high of 5.9% in February.
The Russian invasion of Ukraine has further exacerbated supply chain pressures and inflationary forces around the world, likely keeping inflation at elevated levels for longer than expected. This is reflected in the US 5-year break-even inflation rate, which has climbed to 3.4% from 2% at the start of 2021.
The unemployment rate in the United States has fallen significantly, from 6.7% in December 2020 to 3.6% in March 2022, and the tight labor market is contributing to significant wage pressures and staffing shortages in various sectors, which should persist for some time to come. Input cost pressures also continue to bite, with the S&P GCSI index tracking a basket of more than 20 soft and hard commodities including oil, gas, gold, copper, aluminum , wheat, corn, cotton, cocoa, cattle, etc. 53% since the end of March 2021 and up 65% compared to the start of 2020.
At this time last year, the consensus was that we would not see US interest rate hikes until at least 2024. However, strong macroeconomic conditions and mounting inflationary pressures are forcing the US Federal Reserve and other banks world power plants to act sooner than expected.
The US fed funds rate was raised 25 basis points at the March 2022 meeting and the projection is that we will see further 10 basis point rate hikes by the end of 2023 to 2.75% – as shown by the Fed’s dot chart that outlines the forward path of rate hikes.
In addition to rate hikes, the Fed recently signaled that it would begin shrinking its balance sheet by letting some maturing bonds “run out” without reinvestment, at a maximum monthly rate of $60 billion in Treasuries and $35 billion in mortgage-backed securities.
This process of quantitative tightening should put further upward pressure on long-term interest rates, which have already rebounded sharply in recent months. For example, the 2.77% yield on 10-year US Treasuries is now well above pre-COVID-19 levels and is receding towards the 10-year peak at the end of 2018. borrowing costs such as the large 30-year loan. fixed mortgage rate in the United States which recently rose above 5%, the highest level since 2010, after starting the year at 3.3%.
IMPACT ON STOCK MARKET POSITIONING
As the focus on inflation and interest rates continues to escalate, this should have effects on flows in various parts of the stock market. The end of ‘easy money‘ and higher interest rates have already contributed to some of the heat coming from the more speculative areas of the market, translating into steep declines in the share price of many growth stocks and unprofitable themes that had risen to unsustainable levels and largely ignored the risk of rising rates. For example, the Goldman Sachs index of unprofitable technologies has fallen more than 50% since its peak in February 2021, after an exceptionally strong recovery in 2020.
Heightened inflation expectations and mounting concerns about further interest rate hikes have also led to a recent rotation towards many perceived beneficiaries, including commodity producers, banks and many cyclical industrialists who typically sit in the “value” segment of the market.
As we pointed out last year, this type of rotation is typical of what we expect during the early stages of a cyclical recovery, although it often results in a “rising tide lifting all the boats” where many companies in the most rate-sensitive sectors rise in tandem, regardless of their quality or underlying fundamentals. Our focus on investing in quality companies means that our portfolios could potentially lag the market during this initial rotation, but historically any underperformance has been relatively short-lived.
We would say that as we move forward, many of the “value” companies are much more susceptible to earnings risk than the “quality” companies, since the “quality” companies tend to have better margin profiles, stronger pricing power, more robust free cash flow and less balance sheet leverage, which are important attributes when inflation is running high, rates are rising and economic growth is slowing most likely.
Once the dust settles, we would once again expect investors’ attention to shift to the quality of the underlying companies and their valuations. Ultimately, earnings will be the primary driver of long-term shareholder returns and “quality” companies with more sustainable earnings growth will, in our view, be in the best position to reward investors.
GROWTH vs VALUE
The “growth” versus “value” debate is often front and center for investors, which is understandable given that it can be a key driver of return for many investment strategies. After many years of outperformance of growth assets, the prospect of higher interest rates increases the risk of valuation compression for some growth assets, a large part of whose value is based on long-term cash flows.
While quality investing styles are often growth oriented, we note that the implementation of our Quality Investing at a Reasonable Price (QARP) approach is designed to provide more balanced exposure to a range of quality companies with both growth and value characteristics, although we tend to have little exposure to companies at the extreme ends of the spectrum (i.e. deep cyclical stocks or excessively expensive or unprofitable).
The ultimate goal of our QARP approach is to generate more consistent investment returns across different market conditions, regardless of which style is likely to outperform.
For example, in 2021 we have seen extreme short-term divergences between value and growth, in both directions. Using the MSCI World Value and Growth indices as proxies, we found that value outperformed growth by 5.0% in March and 4.5% in December. At the other end of the spectrum, growth outperformed value by 6.0% in June.
In each of these months, our Global Core, Select and SMID strategies all outperformed their respective benchmarks, demonstrating their ability to deliver strong performance results whether growth or value is in vogue.
OUTLOOK – WHY QARP IN 2022 AND BEYOND
Predicting exactly how the macroeconomic environment and investment markets will evolve over the next 12 months is a difficult task. On the positive side of the equation, GDP growth in many parts of the world is strong, unemployment rates are low, consumer balance sheets are in good shape, and interest rates remain low by historical standards.
However, there are a series of headwinds that could weigh on the markets, including the threat of persistently high inflation and the likelihood of interest rate hikes, continued uncertainty created by geopolitical events, and any new variant of the COVID-19, the negative impacts of supply chain disruptions, the risks associated with the removal of various stimulus measures, and the real threat of slowing global economic growth.
Overall, we think 2022 is likely to be a year when investors finally start to factor more risk into their investment decisions, after a number of years where many risk factors were arguably overlooked. . This type of environment is ripe for our QARP investment approach to be rewarded.
We will continue to work hard to build a portfolio of quality companies with key attributes such as good pricing power, strong balance sheets, sustainable earnings growth and highly visible cash flow, and lower exposure companies with high valuation risk.
We believe that our exposure to companies with these attributes has been one of the main reasons we have been able to outperform during historical periods of rising inflation and interest rates and we have no no reason to believe that this time will be different.
Joel Connell is a senior global equity analyst at Bell Asset Management.