By Dr. JoAnne Feeney, Portfolio Manager
Tensions between the Ukraine and Russia escalated over the weekend, as Russia declared two separatist regions “independent republics” and announced intentions to move “peacekeeping” troops into those regions. Plans for certification of the Nord Stream 2 pipeline from Russia to Germany have been suspended and initial sanctions from NATO allies are coming. The latter may become more severe, depending on the scope of Russia’s invasion, and economic growth may suffer, although the impact would likely be felt primarily in Europe. The risk of a European war combines with ongoing uncertainties in the U.S. of slowing growth, rising interest rates, and ongoing inflation to make some investors nervous. Even so, the investing environment looks just fine if you’re an income investor, but looks like a hot mess if you’re a growth investor. That contrast reflects the “Great Reallocation” initiated in late 2021 as investors began to flee these rising risks. So, while the S&P finished last week down roughly 9% year to date, that headline does not tell us much about the disparate behavior of different types of stocks, nor where they’re likely to go from here. A closer look reveals some notable trends and suggests a path forward.
Volatility, as measured by the CBOE Volatility Index (the VIX), has ticked higher, and could well remain elevated for some time to come. But even in the face of these risks, and the economic slowdown already underway, companies are pushing production higher, incomes are rising, and consumer retail spending remains strong and is now starting to shift toward travel and leisure. Economic recovery is broadening out, and as prime beneficiaries of recovery, energy companies and banks are seeing their stocks appreciate further, after a strong 2021. In addition, real estate companies are benefitting from inflation and interest rate concerns, as their assets tend to be well protected from those two risks. Income investors are doing well (SPYD), but growth investors (SPYG) are facing a very different reality.
While high-dividend stocks (SPYD) are up 1.9% (YTD through 2/18), the S&P 500 is down 8.6%, and growth stocks (SPYG) are down even more at -13.4%. The decline in growth stocks began in early November when investors became convinced that the Federal Reserve would indeed move to curtail inflation by raising interest rates. Since then, and even without the Fed raising rates an iota, the 2-Year Treasury has risen by a full percentage point (from 0.44% to 1.47%). That’s the equivalent of four Fed rate hikes. For companies with valuations based more on future earnings than current earnings, which includes most high P/E multiple stocks, higher rates reduce valuations, because the present value of those future earnings is reduced. In addition, uncertainty regarding the trajectory of economic growth has risen substantially as investors contemplate the risks of a “hard landing” as the Fed attempts to get inflation under control. Add to that the delays in supply chain fixes, still-slow production growth, and higher risk associated with the Ukraine-Russia crisis. This “risk-off” trade has plenty of sources.
So, what will shift growth stocks back to a positive trajectory? A few forces will be at play. Once these stocks are deemed sufficiently cheap to warrant holding even at these higher rates and elevated uncertainty, investors will take advantage of the opportunity to put more appreciation drivers back into their portfolios. The Great Reallocation reflects a shift in exposures and once complete, selling pressure comes off the growth stocks, and the reallocation might even reverse as investors look to build appreciation engines back into portfolios. So, have these stocks become sufficiently cheap? When we look at Info Tech stocks, we notice that the average multiple (P/E) has dropped by 16% since the start of the year:
Source: Factset, 2/18/22
Notice that Info Tech stocks are now trading barely above pre-pandemic levels, when the 2-Year Treasury was at roughly the same level as it is now (that’s also the case for the 10-Year). In late January, we saw investors begin to come back into growth, but both greater geopolitical tensions and the possibility of more rate hikes overwhelmed that move. Yet when we evaluate long-term earnings growth prospects among most of our selections, they remain as robust as they were before the pandemic began (and in some cases higher). Once the reallocation comes to an end, we expect these stocks once again to be driven by incremental increases in earnings—and among growth stocks those increases should be greater than for safer, more stable companies. That return to fundamental drivers has been pushed out by near-term risks, both from geopolitical events and interest rates, and also from the cautious guidance this quarter as supply chain snarls hamper production increases. One positive on the horizon is the coming increase in factory capacity of the semiconductor companies, which is slated to come on line mid-year.
Investing in a period of higher risks tests the patience of all investors, so setting an appropriate mix of equity and fixed income exposure is critical to riding out the volatility to stay the course. Looking back at history tells us that markets recover from even the most severe shocks, including pandemics, wars, and recessions. Those with a long enough horizon can wait out the volatility, but others may want to be more conservative. So, while fixed income may not deliver a lot in the way of portfolio gains during a time of rising rates, a healthy dose of carefully selected bonds and preferreds can deliver some needed income and dampen the volatility in principle. Dividend income can provide that buffer on the equity side. Stay balanced to sleep better and retain some exposure to stocks with solid earnings growth potential to help that principle grow over the longer term. Growth stocks may not come back into favor next week or even for months or quarters, but history tells us it will come.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.