Quality Growth Boutique
Global equities specialists since 1984. We provide a boutique investment experience for institutional and intermediary clients around the world.
Multiple rounds of Covid-relief fiscal stimulus, combined with US President Biden’s recently proposed $2.25 trillion in infrastructure projects, have started to trigger a sense of spending fatigue. It’s only natural to question the implications these programs could have on inflation and interest rates. Parts of the market, such as renewables and green industries, are already factoring in increased spending on infrastructure. However, there is likely to be intense political debate about whether the economy needs more investment, which could bring further volatility this year.
The US suffers from a larger number of unemployed or under-employed. So, there is some potential to have a positive economic impact with minimal inflation or interest rate impact, at least in the short-run, as long as it is primarily stimulating a slack in demand. It’s important to remember, however, that going into the pandemic the US labor market was already running fairly tight, and despite the still high rates of unemployment numbers, businesses seem to be having trouble finding enough workers already in the recovery. If history is any guide, this massive potential spending may, more likely than not, miss the mark. Investors should be wise to prepare for a future where inflation causes some investor anxiety and nervousness.
While higher interest and inflation rates may more predominantly impact owners of long-duration assets in a variety of ways, they are also simply a positive signal of strong economic growth, which is a good thing. They also should enable for a more generally healthy pricing environment for risk assets. Higher interest rates are not necessarily something terrible to be only feared.
For equities, certain industries, such as energy, basic materials or consumer staples, may initially benefit more greatly from rising rates. But over time, as inflationary forces spread, input prices and employee wages rise, starting a cycle that can negate the margin improvements gained from simply raising selling prices. Asset replacement valuations and capex cycles would also be affected. As financial modeling and forecasting becomes more complicated, and with it the economic future of businesses becomes more cloudy, investors would logically and rightly expect a greater margin of safety in the prices they are willing to pay for assets like stocks. So, as yields go up over time, P/Es should likely see some downward pressure as well.
While inflation seems poised to accelerate, the most critical question is the magnitude. Remember, we are coming out of an extended period where rates have been historically low and inflation has not been a concern. Pricing power is the best defense against an inflationary environment. Companies that have pricing power, for example, in the consumer staples and consumer discretionary spaces, are better able to pass on rising input costs and protect margins, and even pass on pure price increases.
News of Biden’s proposed doubling of the capital gains tax for wealthy Americans initially roiled the market; however, as is typically the case, the effect is exaggerated, which is likely why the market seems to be shrugging it off now. In fact, the percent of US corporate equity owned in taxable accounts by Americans is a relatively small piece of the pie—and still there are tools that the wealthy can use to delay paying such a tax. Furthermore, the proposal faces the standard political hurdles in actually passing into law, so it can take some time before we even see it enacted as proposed. Even if enacted, with some government elections occurring every two years in the US, it’s questionable how long it could last given the frequent change in political power, as well as changes in American priorities.
Over the last few months, we’ve seen a market rotation from growth into value stocks. This value rally has been bolstered by the distribution of the vaccine and the continued strong stimulus support, particularly in the US and Europe. Rising 10-year Treasury yields and a view that inflation is picking up have driven some of the more cyclical areas of the market. The good news is that this has been due to signs that many economies are recovering more rapidly than previously projected. At the other end of the spectrum, some of the momentum-driven stocks of 2020 have pulled back.
While a narrow focus on sectors and stocks has delivered outsized returns for some investors in recent quarters, investors need balance to consistently achieve success over the long-term. There are opportunities in the markets today to strike a balance across a variety of sectors, in companies that performed well throughout COVID-19, as well as those that are normalizing after the pandemic. Put simply, we believe investment opportunities through Quality Growth lenses are still broad right now.
It is as important as ever to focus on quality in today’s markets. By looking for companies with consistent and sustainable earnings growth, investors can maintain conviction that these companies should emerge strongly from inevitable ongoing market volatility.
A word of caution: with respect to value, just because something is on sale does not mean it’s a bargain. Look for companies that can compound earnings growth over the long run and favor those with secular or structural drivers to their growth. While quality commands a premium, you should only want to pay a reasonable price relative to growth expectations. Valuation discipline always has been and will continue to be very important, and we think the coming market environment could serve as a healthy reminder of that. Discipline is what separates investors from speculators.
The views and opinions herein are those of the individuals mentioned above and do not reflect the opinions of Vontobel Asset Management or Vontobel Group as a whole. The views may change at any time and without notice. This document is for information purposes only and does not constitute an offer, solicitation or recommendation to buy or sell any investment instruments, to effect any transactions or to conclude any legal act of any kind whatsoever.