Portfolio Manager Jeremiah Buckley discusses the current environment for US large-cap stocks.
- Stocks have suffered a rocky start to the year as investors evaluate the effects of inflation, shifting central bank policy and flaring geopolitical tensions.
- As these macroeconomic forces evolve, two areas we have concentrated on are the status of global supply chains and the durability of secular growth trends.
- From a fundamental level within our focus area of U.S. large caps, data continues to be supportive of corporate growth, and heightened volatility could create opportunity in the asset class for an active focus on specific market segments and businesses.
Following two strong years of market appreciation in 2020 and 2021, the S&P 500® Index recently lost over 10%, correcting after reaching an all-time high on January 3, 2022. The S&P 500® Information Technology Index ‒ which represents the sector driving much of the market’s returns over the last two years (Exhibit 1) ‒ fell even more, declining over 15% since peaking on December 27, 2021.
Exhibit 1: Index Performance 1 January 2020 through to 22 February 2022
Source: Bloomberg, as of 23 February 2022. Past performance is no guarantee of future results.
The market volatility we’ve seen early in 2022 has been stoked by more persistent inflation, shifting central bank policy and flaring geopolitical tensions ‒ most recently, the Russia/Ukraine conflict. While we can’t control these macro developments, we have been particularly focused on two questions as we navigate the volatile investment environment. First, are we beginning to see improvements in the supply chain issues that have been festering since the beginning of the pandemic, and second, are the secular trends that have been driving market and economic growth for the last couple of years likely to continue?
Repairing the Supply Chain
One area of ongoing concern has been the supply of labor. The pandemic substantially reduced labor participation rates, and the resultant shortage of labor has triggered issues along the supply chain, notably in the shipping and transportation of goods. We are beginning to see some improvement as companies are now reporting easier availability of labor, but the extent to which the COVID health environment can continue to improve and reduce the impact on labor supply would likely benefit both prices and economic growth.
Reduced availability of raw materials and essential production components has also added to supply chain complications. However, companies are now seeing some easing in raw material supply, and with respect to component shortages, many businesses are predicting improvement in the second half of 2022. Meaningful progress in these labor and input shortages could significantly slow the higher inflation evident in recent Consumer Price Index (CPI) numbers. Conversely, if inflation persists, central banks could be forced to aggressively increase rates to materially reduce demand, so these factors will bear close monitoring. While we'd like to see more progress on this front, for now, we are at least beginning to see modest improvement in some factors driving global supply chain issues.
Data Supportive of Ongoing Digital Transformation Themes
As a response to current supply chain difficulties, we think there will be an acceleration in corporate investment as companies seek to add more flexibility to their production processes and supply chains. Specifically, as we have previously written, we think we will see an increase in automation and technology spending, which could help address labor shortages and wage pressures while speeding shipping and manufacturing times in sectors such as industrials. Likewise, in the past quarter we saw strong growth data from technology companies that are benefitting from the broad shift across all sectors to a more digital economy ‒ specifically in cloud services, software and semiconductors.
Earnings Remain on Track
Within our area of focus ‒ U.S. large-cap equities ‒ generally, companies exceeded earnings estimates to finish 2021. The small number that had difficulties, that pre-announced or missed forecasts were closely tied to rising petrochemical input costs, which represents a relatively small portion of the market. 2022 earnings guidance has also generally been in line with or better than expectations. We have been reassured by an uptick in dividend payments and share repurchases and, outside of a small number of industries, we continue to see strong corporate capital expenditures (capex), particularly on automation and technology projects such as those mentioned above. Given the recent market pullback, relative valuations for our core universe of stocks are near pre-pandemic levels. So, despite volatility, we maintain a generally positive outlook for equities.
Sector Considerations in a Rising Rate Environment
The interest rate environment and changing central bank policy will certainly impact sector selection. In a world of rising rates, investors may be inclined to tilt to market sectors such as financials that tend to benefit from rising rates, but we would urge caution. While there is potential for higher net interest income with higher rates, investors should also consider that consumer health can shift as rates move higher and impact variables such as loan growth and credit losses. In bond-proxy sectors such as real estate and utilities that have heavy amounts of debt financing, rising rates will increase borrowing costs and could make these investments less attractive on a relative basis than higher-yielding bond alternatives. Lastly, high-growth companies that are not yet profitable or that have negative cash flows can see their valuations erode significantly as interest rates ‒ and, thus, discount rates ‒ rise.
On the other hand, while we will closely watch the impacts of interest rates on consumer spending, we believe there are opportunities to be found within the consumer discretionary sector, supported by healthy wage growth and strong consumer balance sheets. As mentioned previously, there are a number of tech-oriented companies that should see strong secular growth on account of continued spending on the digital transition of the economy, regardless of interest rate movements.
So, there are several factors that lead us to be optimistic within our area of focus of U.S. large caps. From a fundamental level, data generally continues to be supportive of corporate growth, and heightened volatility could create opportunity in the asset class for an active focus on specific market segments and businesses.
Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or "junk" bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Technology industries can be significantly affected by obsolescence of existing technology, short product cycles, falling prices and profits, competition from new market entrants, and general economic conditions. A concentrated investment in a single industry could be more volatile than the performance of less concentrated investments and the market as a whole.
Consumer discretionary industries can be significantly affected by the performance of the overall economy, interest rates, competition, consumer confidence and spending, and changes in demographics and consumer tastes.
Volatility measures risk using the dispersion of returns for a given investment.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.
The S&P 500® Information Technology Index comprises those companies included in the S&P 500 that are classified as members of the GICS® information technology sector.
Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics.