Chapter 36: Earnings Growth Drives Long-Term Valuations
Dear Clients,
In our previous investment outlook from December, we had characterized year 2022’s performance as being impacted by a series of interlinked growth shocks, first stemming from more persistent inflation, followed by the invasion in Ukraine, and finally resulting in a series of expeditious interest rate increases to restrict monetary conditions and slow the pace of inflation. Since the last writing, core inflation likely has already peaked, the employment markets remain resilient, credit quality has withstood a more restrictive monetary environment, and the recalibration in corporate fundamentals has occurred in an orderly fashion. We are at a likely turning point in monetary policy, as the US Federal Reserve contemplates a downshift in the magnitude of its interest rate increases, and an eventual pause in 2023. As a result of the shift in the investment climate, a barbell approach to portfolio construction has been rewarded this year – companies with strong balance sheets and high return of capital characteristics, juxtaposed with deeply discounted earnings growers that are experiencing valuation uplift as the economic recovery unfolds. Overseas re-openings in China in December have buttressed robust travel and entertainment spend, benefiting select areas of the consumer discretionary industry.
In the present investment outlook, updated after Q4 2022’s earnings season has concluded, the economic forecast has been upgraded, with the expectation of a softer landing into a more modest recession than expected before. This is evident in the year-end corporate results spanning from banking to luxury goods as well as areas of the economy that are secular growers, such as research and development (R&D) driven semiconductor companies, where investments into next generation technology continue to be made. As a result, 2023 S&P500 earnings expectations as of March are for mild profit declines of approximately 1%, but this is expected to rebound by 10% in 2024 and a further 9% in 2025 – and it is earnings growth that ultimately drives stock valuations in the long run. Therefore, we have been opportunistically deploying cash in select areas of the economic recovery that will participate in the rebound in earnings once the recalibration has concluded.
On the future investment outlook for the second half of 2023, we also wish to comment on the bond market’s expectation of interest rate cuts later this year. We believe this is an unlikely scenario, as the US Federal Reserve will likely want to see a sustained path back to 2% inflation before easing monetary conditions again. As a result, we expect a “higher for longer” environment to persist for a prolonged period of time, favouring a barbell approach of high earnings growers and stable return of capital companies with fortified balance sheets, such as what we see in select areas of the technology sector. From a fixed income perspective, this would mean that an inverted yield curve would favour long duration positioning in high quality, defensive credits.
Monetary policy operates with long and variable lags, and the effect of last year’s more restrictive policy is being felt in the financial stability issues witnessed among the US regional banks. There are a number of important differences compared to 2008’s financial episode, including the absence of spillover effects into housing, an expeditious regulatory response to contain the impacts, and an idiosyncratic mismatching of assets and liabilities that impacted the deposit bases of select financial institutions. The 2008 events affected the broker-dealer markets, otherwise known as the shadow banking system, where the US Federal Reserve required an expansion in its policy mandate before it could respond in a timely manner. This is the reason the US Federal Reserve downshifted the increase in the overnight rate to 25 basis points on March 22nd, noting that the most recent developments in the US banking sector will likely weigh on economic activity, hiring and inflation. As a result, the terminal fed funds rate was left unchanged at 5.0-5.25%, implying one more 25 basis point interest rate increase before a pause.
In summary, earnings growth drives long-term valuations, and after the profit recalibration we have been expecting this year concludes, we expect this trend to continue. Economic winners will likely include a combination of companies that can return capital expeditiously to investors, in a higher for longer interest rate environment, as well as deeply discounted earnings growers with secular growth characteristics. From a long-term valuation perspective, markets led by solely multiple compression (as we had last year) or multiple expansion are rare, which underscores the durability of an investment process that focuses on selecting high quality earners with strong competitive positions.
We hope clients have enjoyed this installment and we look forward to further interactions.
Warmest wishes for a rejuvenating spring season,
Grace Wang, CIM, PFP | Senior Portfolio Manager
Samuel Jang, CFA | Investment Associate | samuel.jang@rbc.com
Leslie Mah | Associate Advisor | leslie.mah@rbc.com | 604-257-7059
Jennifer Hamilton | Associate | jennifer.hamilton@rbc.com | 604-257-2537
RBC Dominion Securities
Phone: (604) 678-5794
Fax: (604) 257-7391
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