In an inflationary and rising interest rate environment, the overall valuations of growth stocks have adjusted significantly over the past several months, returning to pre-pandemic levels.
High-quality growth companies with strong balance sheet and financial flexibility are well positioned to withstand the slowdown.
Growth stocks valuation attractive
The rotation out of growth, and the compression of multiples of the highest growth companies has been absolutely brutal. So much so that valuations of growth stocks relative to the rest of the market or relative to value stocks have come back to the levels seen in early 2019. The entire valuation premium built up during the pandemic and the ensuing lockdowns has been fully unwound. That does not guarantee they will outperform from here, but it does provide a very good basis for future performance.
Over the last four interest-rate cycles in the past three decades, growth equities did underperform when the interest rate cycle was about to turn. However, in each of those cycles they resumed market leadership when interest rates began to rise, and the markets focus could shift from the question of when will interest rates rise and by how much?
The trajectory of interest rates to the question of the intention behind the policy. The intention in each cycle was, as it is now, to slow the economy down and reduce aggregate demand to ease inflationary pressures. That is much more of a headwind for cyclical and value stocks and for structural growth companies. Once the rate cycle is underway and inflation (and rate) expectations stop rising, then growth stocks tend to resume market leadership.
In the last four rate cycles, the central banks continued to raise rates until they succeeded in slowing the economy and thereby reducing inflationary pressures. For this rate cycle to be different, one would have to assume that the central banks lose their nerve and do not do what is necessary to bring down inflation. If we see that, then inflation could become endemic, and the market dynamic would certainly be different.
We will have a good idea within the next five or six months – having very publicly underestimated inflation last year, will central banks lack the nerve to “do whatever it takes” to bring inflation (and inflation expectations) back down? That should not be anyone’s base case. Once investors can have some confidence on where the peak in inflation and interest rates will be, growth equities should be able to resume their leadership of the equity markets.
Focus on quality growth
We recognise the markets and environment are changing rapidly. Central banks are hawkish as inflation continues to be a persistent problem. At Jennison, we have stuck to our approach and remained true to our philosophy and process, focusing on companies with more immediate earnings/ cashflow (often referred to as quality growth), rather than very high growth (longer duration) companies that are in heavy investment mode. While they are solid long-term opportunities, we know they are likely to be less profitable in the shorter term.
Selective on emerging markets
In the emerging markets, we are selectively positive on fintech in markets where incumbent legacy banks have been inefficient, expensive and slow to embrace the newer and cheaper ways to reach and service customers, leaving more profitable opportunities than in more developed markets where the banks have moved more swiftly to offer digital services.
We see opportunities in Chinese companies that are going to be the growth leaders over the coming years rather than the tech giants that led the market in the last decade. In India, the demographic drivers and digital transformation also promise to be tailwinds over the coming year.
Raj Shant is managing director and portfolio specialist at Jennison Associates, a PGIM business.
