27. Nov. 2023
2023 stands as a compelling case study reinforcing our scepticism about macro forecasting for specific outcomes or environments. In 2023, the US encountered a US banking crisis, conflict in the Middle East, sticky inflation, rising expectations for the Fed funds rate and the 10-year yield at points touching a 5% level, not seen since 2007. Despite all of this, US equities are up double digits as of November, outperforming global peers. I am not sure many would have foreseen this, even with perfect insight into the macro variables.
We would put the outperformance down to the high-quality business models of the companies in the US market, which has made it a great hunting ground for quality ideas over the years. Another more specific driver has been the hype around generative AI. It has been the big theme of 2023 and, considering the bulk of intellectual property and expertise for capitalising on this technology primarily resides within US companies, it underscores their role in this trend.
We would argue that the so-called “Magnificent Seven” are some of the best companies in the world and five of them represent core members of our quality universe in the US: Microsoft, Alphabet, Meta, Nvidia and Apple. Let’s not forget that these businesses’ share prices were down on average about 50% in 2022. So, the rally this year just takes us back to where we were a few years ago.
Of course, there have been some very specific success stories here, most notably Nvidia, which has seen a huge tailwind as customers fight for high-end graphics processing units to power their AI models. As a result, Nvidia has seen a significant increase in its earnings expectations over the course of 2023. We can debate the trajectory and sustainability of Nvidia’s growth profile in 2024 and beyond, but we believe the stock has gone up for good reason.
We would argue that there are three quality sectors that could find favour in 2024: life sciences, animal health and consumer staples. Life sciences companies provide equipment and consumables for a range of industries but, notably laboratories developing drugs for healthcare applications. These have been out of favour in the past few years as the companies have seen declining sales from the high base created by excess demand during the pandemic. Investors have been waiting on the side-lines for earnings to rebase, which we think could be relatively soon. These are high-quality businesses, with long-term tailwinds from the conversion to biological drugs, and in our view 2024 should be a better year for them.
Meanwhile, consumer staples has been out of favour for completely different reasons. We have seen rising long-term yields, shorter-term worries about the outlook for volumes, following the pandemic-driven consumption, and then longer-term concerns about the growth of weight loss drugs and what that might mean for consumption in the long-term. We believe the starting valuations are beginning to factor in these risks. Also, these are business models that should hold up relatively well if we enter a more protracted recessionary environment. So, on a risk-adjusted basis, we think there are worse places to be in 2024 than invested in the consumer staples companies, although you need to be selective about the categories you are exposed to.
Finally, animal health, and particularly companion animal health. These companies have had a relatively disappointing 2023 as the market worries about the post-pandemic pet adoption trends, which have been volatile. A big driver for these companies is vet visitation numbers, which we think are starting to normalise. And when we take a step back and look at the secular growth in animal health, we believe it is well positioned given a growing pet population and increasing willingness for pet parents to spend on their animals. We also think that current valuations are becoming increasingly conducive to an attractive long-term return profile for these companies.
In the near-term, should the Fed need to raise rates higher than the market expects, currently anticipated to peak around 5%, we would expect it to be a headwind for the quality style given its valuation premium. This, of course, works both ways. If we emerge from the current economic volatility into a world of relatively low growth and low inflation, like the environment we experienced pre-COVID, then high-quality growing companies should outperform.
Neither of these views is our base case. In this type of environment where rates remain elevated for longer and with economic growth under pressure, there is, arguably, more opportunity for successful stock-picking for US investors. As such, now more than ever, it is particularly important to understand the business and financial models of the companies held by an investor. We think the importance of balance sheet strength is going to become a crucial differentiator. As investors, we always avoid excessive leverage but, right now we have this combination of forces where interest rates are higher than they have been for a long time, and economic pressure is rising, potentially creating a negative cocktail for leverage businesses out there.
Most US equity strategies are focused on the growth or value styles or a blend of that. A strategy that is focused on quality first, then balancing valuation versus growth as a secondary consideration, is differentiated from the traditional approaches. It should provide the opportunity for resilience in more difficult economic environments, with the long-term compounding of that structural growth opportunity. So overall, quality’s approach should give an attractive and differentiated return product profile as a component of a US equity portfolio.
General risks. All investments carry the risk of capital loss. The value of investments, and any income generated from them, can fall as well as rise and will be affected by changes in interest rates, currency fluctuations, general market conditions and other political, social and economic developments, as well as by specific matters relating to the assets in which the investment strategy invests. If any currency differs from the investor’s home currency, returns may increase or decrease as a result of currency fluctuations. Past performance is not a reliable indicator of future results. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific risks. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Concentrated portfolio: The portfolio invests in a relatively small number of individual holdings. This may mean wider fluctuations in value than more broadly invested portfolios. Style bias: The use of a specific investment style or philosophy can result in particular portfolio characteristics that are different to more broadly-invested portfolios. These differences may mean that, in certain market conditions, the value of the portfolio may decrease while more broadly-invested portfolios might grow.