By C WorldWide Asset Management | October 16, 2021
Bo Knudsen, Managing Director and Portfolio Manager

The recovery of the global economy has sputtered as companies try to make the best of a difficult situation and an uncertain future. Supply chains designed to rely on precise logistics and the orderly flow of goods have heaved with the pressure of the recovery, constraining production across sectors. Bo Knudsen, Managing Director and Portfolio Manager with C WorldWide Asset Management, doesn’t see these problems affecting key growth stocks long term. In their equities outlook, he stands firm on the long-term outlook for ‘compounders’, companies that they believe have the potential for sustainable growth that outpaces rivals and the broader economy. Clients can invest in compounders through the Canada Life™ Pathways International Concentrated Equity Fund.

Stop ‘n go economy creates short-term bottlenecks

We previously advocated for calmness with regard to bond yields. We see interest rate and inflation trends in 2021 and the subsequent market rotations primarily because of an imbalance in the world economy following the lockdowns in 2020. As the economies have reopened, economic growth has surprised positively driven by the proliferation of vaccination programs combined with high savings levels and pent-up consumer demand.

The dramatic and sudden shift in consumer demand has created short-term bottlenecks in several areas – for instance, within the technology sector. The automotive sector in the United States is another example, where sales have historically oscillated around 17 million cars annually. The steep drop in car sales in 2020 is in many ways reminiscent of the development during the last financial crisis, but while it took seven years during the financial crisis to regain previous sales levels, this time it took merely seven months. The sales rebound has actually briefly surpassed the long-term trend. This dramatic stop ‘n go effect causes imbalances and challenges in the production chains, which is the reason for the current bottlenecks and rising prices. In most sectors there is no long-term supply issue - it just takes time to revamp and adjust capacity.

In addition, there has been a noticeable shift in consumption patterns - first from services to products and now the opposite trend, where the service sectors are experiencing high growth. These swift consumption changes require companies to behave with agility and puts strains on the labor market. Such behavioral changes induce short-term bottlenecks. Generally, the global economy has handled this situation reasonably well - not least with the help of effective technology and communication tools.

These consumption effects also raise consumer prices, where the latest survey in the U.S. shows an annual CPI increase of 5%. This development has also influenced long-term inflation expectations, which are now approx. 2.5%, and thus above the U.S. Federal Reserve’s (Fed) long-term target of 2%.

However, increased inflation has not driven long-term interest rates higher. On the contrary, the U.S. 10-year bond yield has actually fallen slightly over the past few months. The self-inflicted recession and the swift reopening have created economic imbalances, where companies need to recalibrate their production capacity and staffing needs. Thereafter, we would expect economic growth, interest rates and inflation to return to their long-term trend. In the U.S., the government increased financial support to the unemployed during the lockdown, but these programs were phased-out in September. This is expected to support labor supply, thereby dampening wage inflation. Volatility acts like a spring with sharp fluctuations in the beginning, where- after the fluctuations become smaller and smaller and the fundamental trend again becomes dominant.

We believe that bond investors are analysing current developments through this prism, while the central banks - despite the recent discussions about possible interest rate hikes in 2023 - continue their support through massive market purchases in the capital markets.

Cyclical sectors in the limelight

Cyclical sectors such as commodities, banks, the automotive sector and other consumer discretionary sectors have experienced a noticeable rebound in the last six to nine months following the steep losses in the spring of 2020. In general, their performance this year has fared better than that of the structural growth companies. Investors have favored the so-called “high octane” companies, where for example cyclical companies in Europe have increased approximately 50% more than their defensive counterparts. We prefer companies that have a strong market position and thereby pricing power, attractive investment opportunities and through the concept of compounding increase the long-term value of the company. This is in contrast to companies that only have pricing power in the first part of the reopening phase, where supply and demand are in imbalance.

Developments in China have a strong influence on the commodity markets and with China implementing tighter credit policies, we are already seeing the dampening effect on commodity prices and the related cyclical industries. When the reopening party is over and the market imbalances are corrected, we expect the fundamentals, and the long-term earnings trajectory of companies will again emerge as the anchor for the direction of equity prices. The companies in our global portfolio increased earnings by 9% during the Covid-19 pandemic in 2020, while earnings for the market fell 16%. In 2021, our portfolio companies continue to maintain a positive development with an expected growth rate of approximately 20%. However, cyclical companies are growing ever-stronger on the back of the economic rebound pushing market earnings growth above 30%. This has been the primary driver of the markets in 2021 with cyclical sectors taking short-term leadership. During periods like this, structural growth companies usually lag the market, which is the reason our global portfolio has – in contrast to last year - underperformed the market in the first half of this year. As the effects of the reopening become more muted and the economic imbalances are corrected, we expect investors to once again focus on the powerful investment concept of companies with the ability to compound.

The big companies defy the law of gravity

It is noteworthy that several of the major companies, especially within the internet space are delivering accelerating growth rates despite their dominant size. As an example, Alphabet (Google) posted revenue growth of 34% in the first quarter of 2021, while Amazon.com lifted revenue 44%. Of further note is that this performance was not the result of a weak comparison on the back of the Covid-induced recession in 2020, but rather evidence of another year in a period of continuous growth. This paints an impressive picture, where the big companies almost defy the law of gravity by continuously gaining market share and accelerating growth rates due to the pervasive trend of digitization. This reveals the value of finding those true compounding companies, where the risk today, especially relating to the technology leaders primarily relates to regulatory interventions.

A positive market outlook

It can be a humiliating experience commenting on the short-term stock market outlook, but we believe the overall trend of the market continues to be positive despite possible risk factors. The most current risk seems to be continued upward inflation pressures forcing central banks to tighten monetary policy more than the capital markets can sustain. The large increases in equities and housing markets - to a large extend driven by low interest rates – make them vulnerable to tighter monetary policies. However, this is not our main scenario. As mentioned, there are valid arguments to expect rising inflation to be short-lived. However, should the inflation trend become stickier, this will not necessarily lead to higher interest rates as central banks are expected to continue to intervene in the bond markets. High government debt levels and the historic need for financing of the much-needed green investments are strong factors supporting continued low real interest rates.

Looking at our points of the compass to understand the future market direction, we have three indicators, where at least two out of three are indicating positive signals. The first is the U.S. economy, which remains the anchor of the global economy and capital markets. The forecast for the U.S. economy on the back of the reopening is a growth rate of approx. 6% in 2021. This is driven by pent-up consumer demand, supported by a consumer in a relatively good financial position given the gains in stock markets and rapidly rising house prices. In the U.S., for example, house prices have risen almost 24% over the last year. Another important indicator is the shape of the yield curve, where a negative yield curve signals a possible coming recession. With the rise in long-term interest rates, the yield curve in the first quarter of this year has exhibited a normal and positive slope, which has provided relief for the banking sector. The last factor is the behavior of the central banks. Over the last 12 months, the European Central Bank (ECB) and the Fed acquired bonds for approximately US$8 trillion. This is a gigantic amount of quantitative easing and is the result of the stimulus packages enacted during the self- inflicted shutdown and recession in 2020. The pace of asset purchases is still very stimulative, although the pace has more or less been halved. Increased inflation pressures have reignited the old debate about tapering. Previous attempts to tighten monetary policy have been problematic for equity markets, but we foresee monetary policy remaining accommodative for quite a while, even with the possibility of tapering being implemented.

In conclusion, there are at least two tailwinds as well as a third one being somewhat positive, although turning more negative. This should provide support for equity markets. We find many attractive investment candidates with a reasonable valuation provided that bond yields don’t rise too strongly. As global economies re-establish a more natural equilibrium correcting the current supply and demand imbalance, we see the current inflation scare subsiding, thus paving the way for the structural slow-growth environment to regain dominance. In this environment, growth stocks that can structurally outgrow nominal GDP growth, will once again become the investment of choice.

The views expressed in this commentary are those of this fund manager as at the date of publication and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice.

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