Quality-growth investing amid inflation and rising rates

The following paper “Quality-growth investing amid inflation and rising rates – December 2021” is contributed by Wellington Management, the sub-manager of the United Global Quality Growth Fund. All views expressed are based on available information as of the date of publication.

With the current blend of macro headwinds and tailwinds, Wellington Management believes it is critical to keep a global growth equities portfolio well balanced. As quality-growth investors, Wellington Management evaluates investments using four factors – quality, growth, valuation upside, and capital return – with varying emphasis based on where we are in the economic cycle. Wellington Management’s proprietary Global Cycle Index (Figure 1) recently peaked and is trending sideways following the largest economic bounce on record. In this environment, Wellington Management weighs each of their four factors equally as they rank stocks in their investment universe and believe that maintaining higher quality and valuation discipline is essential to navigating today’s volatility.

In this short outlook, Wellington Management highlights how this market backdrop may impact growth companies, including those they think are well positioned for the year ahead.

A mix of headwinds and tailwinds

First, it is important to evaluate the macro factors currently affecting growth equities. The combination of effective vaccines and treatments against COVID-19, unprecedented government monetary and fiscal stimulus worldwide, and positive consumer confidence drove economic growth this past year.

FIGURE 1: Global cycle has peaked and is trending sideways

Y/Y global equity market performance vs the Global Cycle Index¹

¹The Global Cycle Index is Wellington Management’s proprietary index constructed to quantify trends in global economic activity and is a combination of seven components: industrial confidence, consumer confidence, capacity utilisation, unemployment rate, global curve, policy uncertainty, and M&A activity. The Global Cycle Index combines these seven forward-looking macro variables and assumptions to indicate the direction of the global economic cycle. Assumptions are based on historical performance and expectations of future outcomes, and, as such, the analysis is subject to numerous limitations. Future occurrences and results will differ, perhaps significantly, from those reflected in the assumptions. Chart data: 31 January 1988 – 30 September 2021. Sources: Wellington Management, MSCI, Bloomberg, Datastream | ²Total time period

PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE.

But the tailwinds from 2021 are now driving headwinds as inflation increases and the US Federal Reserve begins to taper bond purchases in 2022, raising interest rates. Notably, Wellington Management believes the market will price in more persistent inflation, which may hit a 30-year high in September 2022. They expect economic growth to slow in the first half of 2022 as higher prices for energy and other goods weigh on consumer confidence and squeeze real incomes unless wages rise enough to support reflation.

In Wellington Management’s view, it is crucial to next consider how different growth companies behave amid these diverse factors.

Rising rates’ impact on growth

The effect of rising rates varies significantly across companies and sectors. On the positive side, high-quality growth financials can benefit from exposure to wider interest-rate spreads. For example, wealth management companies can charge higher fees on cash balances, banks’ net interest margins should expand as rates go up, and demand continues to increase for private equity investments that are uncorrelated with public equities.

On the other hand, when interest rates rise, valuation discipline becomes even more important, in Wellington Management’s view. This is particularly true when investing in growth equities. Higher rates impact more expensive, higher-multiple stocks as their cost of capital rises. For instance, Wellington Management sees examples of this among some technology stocks. This is one reason why they view that valuation discipline is an essential input into their process. Wellington Management typically looks for stocks that have a minimum of 10% valuation upside potential and also seek to avoid exaggerated free-cash-flow yield valuation multiples. In addition, companies with more balance-sheet leverage and emerging markets countries with high levels of dollar-denominated debt may struggle in a higher-interest-rate environment. Their focus on high-quality companies generating strong free-cash-flow margins with low debt levels is therefore especially important in this environment.

Growth companies amid inflation

Similarly, the impacts of inflationary pressures range widely across companies and sectors. Some can absorb higher cost inputs without sacrificing margins because they have the pricing power to pass these costs on to their customers. Such companies exist in the software and services, healthcare, data analytics, and industrial sectors. In Wellington Management’s view, these businesses are attractive in this environment as they have pricing power because their products and services are unique and high-value, improve efficiency, lower costs, and are mission-critical for their customers.

Conversely, companies that sell products that are less differentiated or lower value-add may lack pricing power, particularly given the price transparency available online. For example, consumer staples companies are more vulnerable to today’s rising inflationary pressures. These companies absorb higher raw material and transportation costs without fully passing these costs on to their customers, resulting in lower margins. Wage inflation also puts margin pressure on companies with high labour costs, such as those in the consumer services or consulting sectors. Notably, leading companies operating on a global scale are less susceptible to wage inflation as they have better technology platforms to hire and train people and recruit from different countries, which is more difficult for smaller companies.

Growth opportunities in China

Lastly, Wellington Management believes China offers strong economic growth potential and investment opportunities in 2022. The country tightened liquidity with increased regulations during 2021. As a result, China’s increase in economic growth was low relative to other major countries, and its equities lagged. However, Wellington Management believes China may still be offering investment opportunities and attractive valuations, as they expect the government to stimulate the economy in 2022 while the rest of the world tightens. Furthermore, they anticipate that China’s regulatory activity seen this past year will slow down.

In particular, Wellington Management likes consumer, internet, and healthcare companies in China as they think these sectors may benefit from secular government support for growth as well as an emerging middle class with discretionary income to spend on goods and services.

Bottom line

Today’s markets are influenced by strong macroeconomic forces, including government stimulus, rising interest rates, inflation, and regulation. As growth equity investors, Wellington Management finds it easier to navigate this volatile environment by adhering to their disciplined, structured philosophy and process. Looking to 2022 and beyond, Wellington Management believes this approach to identifying potential high-quality companies with growth potential, valuation upside, and capital return to shareholders is especially important in this market.

Download PDF