The hallmark of large-cap growth equities in 2022 has been a dramatic reversal in performance. The overall market experienced the same performance whiplash, but innovation-driven areas like technology – which had produced outsized shareholder returns over prior years − have been particularly hard hit. That said, large-cap growth stocks have still outperformed the broader market and their value-oriented peers over the last three and five years.¹

A reset in market valuations

Multiples could contract further as the market determines how to price stocks in anticipation of the ultimate resting point for interest rates and earnings in the coming year. That said, valuations are now at levels seen during the pandemic-induced sell-off in the spring of 2020. The Russell 1000 Growth Index is trading at roughly 21 times the next 12 months’ expected earnings per share, with expectations for roughly 13% earnings growth following a flat year of growth in 2022.² While not extremely inexpensive by historical standards, we believe there are competitively advantaged, materially higher-growth companies now trading at valuations similar to the overall benchmark.

What can slow inflation?

The reset in valuations was triggered by stubborn inflation and the US Federal Reserve’s (Fed) forceful tightening of monetary policy in response. For inflation to fall, we will need to see easing in consumer strength, which has been supported in recent years by multiple factors, including government stimulus, rising wages, strong housing and capital markets, and pent-up demand.

Now, we are beginning to see consumers spend at a rate faster than income growth, which is unsustainable. Personal savings are also being drawn down, and there has been an uptick in the use of revolving (credit card) debt. These metrics all point to an eventual slowdown in consumer spending. We have begun to see initial signs that inflation may have peaked. The two most recent monthly consumer price index (CPI) readings have shown a moderation in prices, and we are also starting to see a decline in transactions for financeable goods, which could force prices lower.

At the same time as the Fed is negotiating resilient consumer demand, it is also dealing with the unexpected shock of the Russia-Ukraine war, which has kept upward pressure on prices, particularly in commodities. Any resolution of this or other geopolitical tensions could help further ease inflationary headwinds in the coming year.

How are secular investment themes being impacted?

We believe that all companies are, or need to be, “technology” companies to some extent. That is, they must decide how to harness and leverage technology to survive and grow in the long term. Thus, we believe that digital transformation across all segments of the economy – which we have talked about for some time – will continue.

More specifically, we think that long-term secular demand for semiconductors will increase in the coming years, driven in part by tailwinds such as the transition to greener energy production and increased adoption of electric vehicles (EVs). For example, physical assets such as agricultural equipment and commercial transportation, along with wind and solar farms, will be “smarter” in the future and require increased semiconductor content. Likewise, EVs will rely far more heavily on microchips than the internal-combustion vehicles they will replace.

We also continue to believe that all companies aspire to be more productive and more agile, and this requires continued investment in software. While we anticipate that growth will slow as we potentially enter a recession, we still expect these areas to expand well in excess of gross domestic product (GDP) growth.

Following a 40-year period of globalization − which drove some industrial functions to other nations and away from domestic manufacturing − we believe that the U.S. is now in a period of deglobalization and reindustrialization. Supply-chain issues and national security concerns, which were brought to a head by the pandemic and recent geopolitical strife, have helped solidify these long-term themes, which will fuel an increase in onshore production and accompanying automation.

Factory automation may be further spurred by increased labor costs, particularly in low-end wages, from the ending of global labor arbitrage. As economies deglobalize and barriers to trade and immigration are fortified, jobs will no longer necessarily move to areas where costs are cheapest. Along with an overall spike in wage growth, we have already seen faster increases among the lowest 25% of workers, as illustrated in Figure 1 below.

Figure 1: Monthly wage growth

Sources: Current Population Survey, Bureau of Labor Statistics, and Federal Reserve Bank of Atlanta Calculations. The data are 12-month moving averages of monthly median wage growth for each average wage quartile.

What can drive individual company growth moving forward?

These secular trends, among others, can provide tailwinds in coming years. At the individual company level, as the cost of capital has increased, businesses that have relied on extremely cheap funding for growth will be tested. On the other hand, firms with competitive advantages that have significant cash on their balance sheets will have greater ability to invest for future growth, even in an economic downturn. These businesses may be able to accelerate market share gains, whereas weaker competitors could disappear.

Overall, we are increasingly excited about the opportunities we are seeing in growth equities. We are cognizant that we are entering a period of structurally higher rates and inflation. We also recognize that it may be more challenging for companies to expand valuation multiples and/or improve profit margins. That said, we take comfort in owning a concentrated set of innovative companies with significant competitive advantages and the potential to drive sustainable growth in revenue and cash flow.

 

IMPORTANT INFORMATION

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.