abrdn: Quality stocks – shaken but sound

Recent market conditions have presented challenges for quality-focused investors. After years in the doldrums, lower-quality, cyclical companies are enjoying a moment in the sun. However, over a longer investment time-horizon (three to five years), value rallies like this one tend to fade.

We believe the sound fundamentals of quality companies give scope for better-than-expected earnings and total returns. And historically, they have proved more resilient when economic conditions get tough. Moreover, by taking advantage of opportunities presented in the current market, quality investors can lay the groundwork for future returns.

Choppy waters

Following three years of back-to-back strength across most global regions, equity markets have begun 2022 with a sharp sell-off and a strong rotation from growth stocks to value stocks.

Investors have turned their attention from company fundamentals to macroeconomics and relative valuations

At the time of writing, so far this year global equities are down 4.0%*and the NASDAQ technology index is down 7.6%. As often happens at the start of the year when we’re waiting for data from the upcoming earnings season, investors have turned their attention from company fundamentals to macroeconomics and relative valuations.

In recent years, the dominant market context has been one of low growth, low inflation and low interest rates. That’s now shifting, and investors see the current environment as a sign of potential regime change. So they’ve shunned longer-term and higher-valuation growth stocks in favour of cheaper cyclicals, companies with improving short-term cashflows and companies likely to benefit from rising interest rates.

Why are investors rotating into value stocks?

Among the many factors influencing recent market moves are, in particular, inflation, interest rate expectations and Omicron, as well as investor positioning and market sentiment. But while each of these is a near-term headwind for quality stocks, in our view, they do not detract from the long-term investment case for these companies.

Inflation and interest rate expectations

Responding to steadily rising levels of inflation across world markets, central banks adopted a more hawkish tone towards end-2021. Most notably, the US Federal Reserve (Fed) said it may stop referring to inflation as ‘transitory’. Since then, US bond yields have jumped, now pricing in five US interest-rate rises by end-2022.

Near-term impact

• Analysts use interest rates to value a company’s expected earnings and cashflows, from which they determine a fair price for the company’s shares. Higher interest rates have led to a derating for higher-valuation and long-term growth stocks. However, in our view, there are structural issues (such as the weight of debt on government balance sheets) that will curb rates from rising much beyond here.

Long-term impact

• Sharply rising inflation creates a testing environment for companies that lack pricing power and good control of their operational costs. Quality companies with strong business models and defendable competitive moats typically have both these attributes. As the market focus returns to company fundamentals, earnings growth and returns will again become the main driver of relative performance.
• Certainly, some cyclical sectors, especially banks and other financials, will see a direct boost to earnings from higher interest rates. But many lower-quality businesses with significant debt will see the opposite effect. And, ultimately, we still expect interest rates to remain low relative to history. So, for many interest-rate-sensitive stocks, the market may already have priced in much of the likely benefit from rising rates.

Omicron

While rates of Covid-19 infection have accelerated with the Omicron strain, its apparently more benign nature may herald the beginning of the end of the pandemic. Vaccine rollouts too have helped weaken the link between infection and hospitalisation.

Near-term impact

• Optimism that the worst may be over has encouraged investors to take a more pro-cyclical stance in developed markets, where vaccination programmes are more mature and economies closer to full reopening. Investors have understandably taken the view that quality businesses stand to benefit less from reopening, given their resilience through the pandemic.

Long-term impact

• It’s possible that 2022 is the year Covid-19 loosens its day-to-day grip on our lives, but its shadow will linger for some time yet. We’ve seen the importance of robust supply chains. Global trade will take time to get back to normal. And, with the relentless march of globalisation perhaps being called into question, many firms may have to rethink their business models.
• For the second time in just over a decade, a global crisis has highlighted the importance of strong balance sheets that can weather unexpected shocks. Events of the last two years have reinforced the justification for the higher valuations of quality firms. A cyclical bounce as we exit the pandemic does not dent the weight of that lesson.

Investor positioning and market sentiment

Growth stocks have performed strongly over the last decade. Now, with interest rate expectations changing, many investors have sought to re-balance their portfolios. And, with relatively concentrated positions in ‘pandemic winners’, investors have tilted towards out-of-favour companies on cheaper valuations with more cyclical exposure.

Near-term impact

• In broad terms, energy, banking and travel & leisure stocks have been notable beneficiaries of the market rotation from quality to value. Companies in these sectors tend to score lower on ‘quality’ criteria.

Long-term impact

• Conversely, sectors with greater quality exposure such as healthcare, staples and technology, have suffered in the rotation. However, given the strong structural drivers of these sectors, such a rotation can’t continue indefinitely. Moreover, overall market sentiment has been turning noticeably more negative in recent weeks. In the context of an ongoing global pandemic, excessive rate hikes while growth is slowing risks choking off economic recovery altogether. On top of this are mounting geopolitical risks emanating from Russia and Ukraine. Investors’ concerns are reflected in the S&P 500 put-call ratio, an indicator of market sentiment, which has recently hit its highest level since the March 2020 market sell-off.

• An environment of weakening economic dynamics and investor sentiment should be relatively supportive for companies with greater visibility over their earnings, less reliance on cyclical growth and with stronger finances. It’s notable the business performance of many quality firms remains robust, despite weakness in their share prices. We believe this bodes well for performance once fundamentals reassert.

What’s the outlook?

Despite more hawkish commentary from the Fed, we believe the outlook for equities remains favourable, given corporate earnings growth and global demand prospects. Further to that, we would make the following observations.

• Interest rate hiking cycles do tend to bring volatility to markets. But history suggests stocks generally recover and perform well once investors have got over the initial indigestion.
• We’re mindful of the increasing risks of a policy mistake. With positive-but-slowing growth at a time of rapidly rising interest rates, there’s scope for the Fed to move too far, too fast. If this happened alongside an economic slowdown, we believe the resilience offered by quality companies is very attractive.
• Importantly, periods when value stocks significantly outperform can be powerful but also tend to be shorter and sharper. We’ve already seen a sharp rotation, and it’s possible the value rally may largely be over.
• It’s also worth noting that, despite their weaker share prices, little has changed in the earnings potential and growth opportunities for quality companies. Earnings releases for 2021 so far support that view. This is particularly important because as the cycle matures it tends to be earnings growth that drives share price performance.
• If economic conditions do weaken from here, the resilience of earnings and financial strength that quality companies offer may well return to investors’ favour.

Summary

Despite a challenging start to the year, we remain confident in the long-term prospects of quality companies, and in their ability to navigate the current climate and deliver superior outcomes for investors.

*as measured by the MSCI ACWI Index

RISK WARNING

The value of investments, and the income from them, can go down as well as up and you may get back less than the amount invested.