While bouts of market volatility are likely to continue amid divergent macroeconomic themes, Portfolio Manager Doug Rao remains constructive on the prospects for growth in the coming year.
- Strong consumer spend has clashed with the spread of COVID variants and broadening supply chain disruptions, dampening economic growth and leading to upward inflationary pressures.
- Consumer balance sheets remain generally strong, bolstered by stimulus, strong capital markets and a robust housing market. While we expect stimulus-driven spend to abate, we think consumer spend can increase at a healthy pace, driven by both elevated savings rates and rising wage inflation.
- We believe digital transformation will continue to be a primary driver of economic growth.
We saw markets touch all-time highs in recent months, only to be met with volatility from the emergence of the COVID Omicron variant. It is too early to know the potency of the new strain and its eventual economic impact; however, vaccination rates are significantly higher now than earlier in the year, with approximately 70% of the U.S. population at least partially vaccinated.1 This higher rate of inoculation, combined with the imminent arrival of oral antiviral drugs, could help lessen the health risks posed by the variant. Thus far, each new virus strain has had a reduced economic impact, and the government seems unlikely to impose widespread lockdowns like those seen early in the pandemic.
That said, the endemic phase of this pandemic has been following an unforecastable path. One of the central questions is whether we will be in a “capital E” or “lowercase e” phase of the endemic in 2022, and that will depend on how manageable the virus becomes in the months ahead. While we remain acutely aware of the ongoing risks, overall we remain constructive on the growth prospects for corporate America in the coming year. As always, we think investors would be wise to focus on the factors driving long-term growth as we continue to work through the ebb and flow of the pandemic.
The spread of the COVID Delta ‒ and now, Omicron ‒ variants, broadening supply chain disruptions and inflationary pressures have surely dampened growth to some extent, but we believe economic activity can continue to normalize as we move into 2022 and expect a healthy year for earnings growth. The supply chain issues that we have all experienced were a result of both supply- and demand-driven factors: First, we had the panicked cancellation of orders at the beginning of the pandemic and the COVID-driven factory closures that created supply disruptions. This was followed by significant government stimulus and consumers’ inability to spend that stimulus on services such as travel and restaurant visits due to the pandemic, which ultimately led to above-trend consumption of goods by U.S. consumers.
We are confident that these factors are beginning to normalize; however, in order for the economy to shift back to a healthier balance between goods and services, a more benign COVID environment is required. When economic normalization occurs, interest rate normalization will also occur ‒ continuing the tug-of-war between rates and valuations we have witnessed over previous quarters and increasing the likelihood for continued bouts of market volatility.
As these factors normalize, we expect many of the current inflation concerns will prove temporal. But as the U.S. economy retrenches away from globalization, we do believe we are in the early innings of sustained lower-income wage inflation. Our expectation is that this wage inflation will create some headwinds on margins for companies without pricing power; however, this should be offset by higher levels of general spend within the economy. We believe that in either an inflationary or deflationary environment, one of the most important business attributes to have is pricing power; thus, we think it is important to invest in companies with the ability to raise prices as they see fit.
2021 has seen a strong rebound in some cyclical value-oriented stocks, but we continue to believe that digitization across economic sectors will be a primary driver of durable growth moving forward. To highlight this point, we can compare forecasted capital expenditures (capex) ‒ which include investment for future growth projects ‒ for a stock in the energy sector with several growth-oriented stocks. While ExxonMobil is expected to invest a significant $22 billion in capex in 2022, Amazon is expected to spend $46 billion, with a number of other growth-oriented companies expected to spend $28 billion or more.2
So, while the threat of inflation does exist, equities with free-cash-flow yields that are higher than other asset class yields, combined with the potential for significant free-cash-flow growth, appear attractive on a relative basis. We think that companies with promising reinvestment opportunities, trusted relationships with their customers and some degree of pricing power can remain effective, regardless of whether we are investing in an inflationary or deflationary environment.
1Source: Centers for Disease Control, as of 11/30/21.
2Source: Bloomberg and company commentary.