US equities portfolio manager Brian Demain discusses what a fundamentally-changed market could mean for mid-cap growth investors.
- For the last two years, we have warned of excesses building in the US mid-cap growth market as valuations for certain companies became extremely expensive.
- A marked shift in monetary policy by the Federal Reserve (Fed) has now triggered a significant drawdown, particularly in high-growth, high-valuation companies.
- As some excesses of the past two years begin to ease, we consider the potential impacts to US mid-cap growth equities.
US mid-cap growth stocks have entered a bear market (down over 20% from their most recent high). Investors began to process the consequences of an impending change in monetary policy and higher rates, and markets have since continued to drop on the realisation that the rate increases necessary to combat inflation will impact both the economy and the appropriate valuation of financial assets. The Russell MidCap® Growth Index was recently down over 30% from its peak in November of last year, and the Federal Reserve (Fed) has now distinctly shifted from an extremely accommodative policy stance to one of aggressive tightening to fight inflation.
Figure 1: Russell MidCap Growth Index Performance (11/16/21 – 5/16/22)
Source: Bloomberg, as of 16 May 2022.
Inflation (and volatility) are likely to persist
It has become clear over the past several months that we are moving away from the environment of low inflation and low interest rates that we’ve experienced over the past 10 years. While we do not think we are entering a decade of 7% or 8% inflation (the estimates we have seen in recent months), we also do not think we will return to the 0% to 2% inflation we saw for much of the 2010s. The US economy is likely to endure real, sustained inflation, forcing the Fed to raise rates. The market action we have seen since the fourth quarter of 2021 is the result of investors processing this paradigm shift. While we believe a series of rate hikes is now largely priced in, uncertainties around inflation and Fed policy point to continued volatility, especially if we see a meaningful slowdown in economic growth.
As investors contend with a higher-rate regime, we are also seeing companies confront some of the externalities of globalisation, including supply chain disruptions, higher transportation costs and geopolitical uncertainty. The war in Ukraine and ongoing COVID-19 shutdowns in China are just the latest developments causing companies to reconsider where they are sourcing their materials and producing products. We are already seeing moves toward re-shoring and new supply relationships, but these shifts may also add to near-term volatility and inflation.
Cyclical vs. growth in a changed environment
The valuations afforded to cyclical stocks are generally less impacted by higher rates than growth stocks, so these names have held up well during the volatility thus far. However, we think higher rates will ultimately hurt these pockets of the market, too. As rates move higher, we will see impacts to the real economy in areas such as mortgage origination and new corporate investment. Over time, higher rates will hurt cyclicals' earnings, and for now it is hard to find areas of the market that are not negatively affected by the dynamics at work.
Are valuations now reasonable?
In recent years, investors attached more importance to future growth than they have in the past, resulting in elevated valuations. Through this time, we cautioned that when stocks reach very high valuation metrics, they rarely produce the type of forward growth rates that would justify their valuations. As recently as the beginning of this year, over 20% of the mid-cap growth index traded at greater than 20x Price/Sales (P/S). That dynamic changed swiftly as markets corrected; only 4% of companies in the index now trade at that level.
Figure 2: Russell MidCap Growth Index Weight of Stocks with P/S>20 (12/31/91 – 5/16/22)
Source: FactSet, as of 16 May 2022.
While investors have shed risky investments in recent months, it remains to be seen if today’s more reasonable valuations are still too optimistic. This is likely the case for some companies, and we believe caution is warranted. Earnings results have remained generally positive, but some businesses are beginning to revise forward-looking guidance lower, which could lead to further deterioration in sentiment.
That said, recent declines have been more evenly spread across valuation levels, in contrast to the last two years, where the most expensive and most speculative names dramatically outperformed the rest of the index. We think this new setting favours individual stock selection, making strong businesses ‒ including some that were previously overpriced according to our valuations ‒ more attractive. In our opinion, these reasonably valued growth companies with healthy balance sheets, experienced management teams and strong market positions have the potential to invest cash wisely, drive high returns on invested capital and create value for shareholders over time.
Monetary policy refers to the policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.
Growth stocks are subject to increased risk of loss and price volatility and may not realise their perceived growth potential.
Smaller capitalisation securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalisation securities.
Volatility measures risk using the dispersion of returns for a given investment.
Russell Midcap® Growth Index reflects the performance of US mid-cap equities with higher price-to-book ratios and higher forecasted growth values.