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Growth Equities Outlook: Fertile Grounds

ERICK F. MARONAK 30-Nov-2021

Heading into year-end, concerns regarding inflation in all its forms (energy prices, interest rates and unit labor costs) have been further amplified by fears of persistent supply chain disruptions. Add to that a tidal wave of resignations in the latest jobs data, and it’s clear why sentiment has turned negative for many growth investors in recent months. 


But it need not be all doom and gloom. In fact, there are reasons for optimism, especially if we reflect on our experiences from earlier in the pandemic. Those companies that can help propel the economic recovery and overcome challenges—including rising inflation expectations—are likely to enjoy success in 2022 and beyond. Many of these candidates are compelling growth companies.

 

How did we get here?


In October 2021, the Consumer Price Index continued trending higher and climbed to 6.2%, according to the U.S. Bureau of Labor Statistics, which is the highest inflation rate in three decades. This is well above the Federal Reserve’s target and has been worrisome to many investors. That only heightened the ongoing debate as to whether inflation is transitory, permanent, or likely to increase even more. While the answer in the short term is almost impossible to know, a longer-term view offers more valuable information if we step back to evaluate the root causes of inflation and, especially, the possible remedies.


Early in the pandemic we witnessed the first wave of supply shortages as significant parts of the economy, including transportation, shut down. Everyday household items were bought in record amounts as consumers realized depleted inventories were not going to be replenished at a normal pace. Thankfully, and despite the enormous human tragedy and widespread economic damage, we seemed to have gotten through the worst of the pandemic. Elected officials and the Federal Reserve acted swiftly and provided much needed stimulus and liquidity, while technology made it possible to work and communicate from anywhere. Vaccines were developed on a globally collaborative basis in record time. The companies that provided consumers or businesses with the tools and services to traverse the turbulence proved indispensable. They accelerated their own growth by several years and were commensurately rewarded. Many of these businesses were categorized as growth stocks.


In 2021, many investors leaned into the hardest hit industries and sectors (many of which were value stocks) as earnings for those companies tended to show the greatest improvement versus last year as the economy rebounded to pre-pandemic levels. Much economic progress has been made across the economy—Delta variant delays notwithstanding—but there is plenty of work to be done, particularly in industries like airlines, hospitality, and food service. Today, some of the bigger threats to the ongoing economic recovery remain supply chain disruptions, labor shortages, and of course, inflation. Unsurprisingly, these issues are all related.


Although there are many measures of inflation, the simplest definition is really just too much money chasing too few goods. Consumers flush with cash have been spending as fast as the economy has been re-opening. The inventory-to-sales ratio, as tracked by the US Census Bureau, is at a 10-year low, a consequence of retail sales increasing almost 15% for the first nine months of this year versus 2020. Shipping congestion was exacerbated by the Suez Canal gridlock in March, as well as an ongoing shortage of dock workers and truck drivers. 


Enduring in the New Normal


While many are looking to the Federal Reserve to contain inflationary pressures, there are a few concomitant tools available. First, as the bond market anticipates a higher level of inflation, capital will cost more as interest rates rise. Less abundant capital will put a premium on companies that have less debt and can self-finance current operations, R&D, and future growth. 


Similarly, consumers will likely become more discrete with spending and less willing to quit jobs as stimulus recedes. That should alleviate some labor tightness. However, as companies search for more immediate stopgap measures, they will inevitably depend on technology and services that increase productivity. This is exactly the type of growth company that may excel in the new environment. Already we saw many such firms that facilitated the work-from-home trend excel in the early days of the pandemic. What’s in front of us now appears to be a second chapter of that story. Companies realize that they will not be able to pass on all price hikes to consumers indefinitely without risking demand destruction or market share loss, so they will look to the companies that can provide the wherewithal to improve efficiencies and cut costs.  


Thus, despite the readily accepted conclusion that rising interest rates hurt long duration assets like growth stocks, it is worth considering that what worked in 2020 might actually work again in 2022 and beyond. Conventional wisdom suggests that the inflation beneficiaries will be companies that have pricing power. This may be true if you time the cycle correctly. But there are other approaches to consider as well. Companies that provide superior solutions to inflation (and other problems) may have a long runway of earnings growth irrespective of prevailing inflationary trends. Many of those companies also have the added attraction of having highly profitable, subscription-based business models that generate cash, while limiting the need for new debt. Therefore, when we look out to a higher inflation environment, we see ample opportunities to allocate to a compelling set of growth companies.