My name is Zehrid Osmani, Portfolio Manager of the Global Long-Term Unconstrained strategy at Martin Currie, with an update on the first quarter performance of 2023.
After the sell-off last year in quality growth stocks triggered by the fastest pace of rate hikes in decades, the first quarter of 2023 saw a sharp rebound in Quality and Growth, which outperformed Value. From a regional perspective, Europe also strongly outperformed the US over the quarter. In line with our 2023 outlook, the return to favour of growth stocks was largely driven by the market’s anticipation of an imminent end to the rate hike cycle. China’s swift re-opening has contributed to a less bleak macro-outlook for the global economy, especially Europe, which is more internationally exposed compared to the US. Against this context, investors moved from defensive areas of the market into more economically sensitive sectors such as IT, Consumer Discretionary and Industrials over the quarter; we have also started to see flows coming back into European equities, which are much more attractively priced, and more cyclically sensitive than the US.
How will Growth stocks behave over the next few quarters will continued to be dictated by inflation and central bank policies, in our view. For now, central banks appear resolute in combating inflation. However, the recent turmoil in the banking sector is adding complexity to their mandate, with potential concern of financial stability. Whilst we continue to believe that systemic risk and is low, the several bank failures across the US and Europe will likely have implications in terms of tighter credit lending conditions, which could implicitly achieve the equivalent of additional rate hikes that some economists have quantified at between 30-150bps. It is unclear whether these events in the banking sector will remain localised, and contained, or spread further. At this stage, we believe that contagion risk remains low, although the situation is fluid, and needs constant monitoring. What this could imply however is that we could be closer to the end of this rate hike cycle, which should be supportive of quality growth stocks.
As a high conviction quality growth manager, we select companies that are able to generate ROICs superior to their cost of capital (the essence of value creation), as well as growth on a sustainable basis, in other words, companies that create value for our shareholders. This philosophy means that we have had no exposure to the banking sector. In addition, we are focused on larger cap, liquid, and profitable growth companies, with resilient earnings, pricing power, strong balance sheet, and structural growth prospects. This positions us well to weather the challenges of broad based earnings downgrade, stickier inflation, risk of recession and a lower growth environment in general. We are also more immune to the potential funding issues that could face smaller, unprofitable growth companies in the wake of the recent banking issues.
Performance over Q1
Against this backdrop, the strategy has also outperformed both quality and growth style indices during the period, with stock selection being the primary driver of outperformance.
In particular, Nvidia highlighted during its weeklong GTC Developer Conference that we attended in March, that AI has hit an inflexion point, in the sense that generative AI is now making inroads into various industries. Generative AI is a technology that can produce various content including text, imagery and audio, leading to applications such as personalised images and text in Marketing, more efficient delivery of Design, Education or Writing, sensing in Robotics – to name a few potential applications. There are challenges that come with new technologies, but Nvidia is a key enabler of Generative AI, uniquely positioned within the ecosystem, so we would expect the company to play an instrumental role in driving various technological waves.
Our luxury goods exposure generally benefitted from the reopening of China, and expectations that Chinese consumers would be able to travel freely around Europe. We believe the gradual normalization of the Chinese economy and resumption of travel should support their earnings and share price over the coming quarters. However, the reason why we like luxury within Consumers is because they benefit from the relatively resilient consumer spending power from higher income households. We also like these companies for their strong pricing power, which helps protect margins, and the thematic trends they can capture over a longer time frame, such as the rising middle class in emerging markets, which will sustain their growth.
The only notable negative contributor is Wuxi Biologics, which sold off due to the weakness in the Chinese market, despite the company reporting yet another set of strong quarterly results.
Sector attribution was also positive in Q1, partly driven by our OW in Consumer Discretionary and IT. Not owning any banks or energy stocks also helped reduce performance volatility last quarter. Our strategy has not owned banks in the past, as a result of our fundamental research process, which we’ve explained in detail in our write up called ‘why we do not invest in banks’, available on Martin Currie’s website.
Finally, in our global strategy we are OW Europe on valuation grounds. This was a positive factor to our relative performance.
During Q1, we’ve purchased a new company, Pernod Ricard, into the portfolio. Pernod is the World no. 1 for premium spirit and No. 2 in the Wine and Spirit industry1. The company is well placed to capture the premiumisation trend in the mid-term. It has strong pricing power and a supportive growth and returns profile.
Our investment outlook
We believe markets are likely to remain volatile over the coming quarters, given the range of outcomes that are being forecast in terms of monetary policy and economic scenarios.
On the inflation front, whilst inflation rates are easing, they are in our view likely to remain sticky, with wage inflation continuing to be the focal point. We should however see an easing to the inflationary pressures in the second half of the year, in large part related to the elevated base effects of last year.
Monetary policies remain uncertain as central banks are faced with very complicated mandates. However, the wide range of outcome on the monetary policies front is what will drive an important bull-bear debate across asset classes. An early ending to the hiking cycle would be supportive for markets, and for the Quality and Growth styles within equities. We believe that we are nearing the end of the hiking cycle over the next 6-9 months, and expect the market to be starting to anticipate this.
On the macroeconomic cycle, we expect the Chinese leading indicators to continue to show a supportive picture in the months to come. With China being the second largest economy globally, its recovery also has the potential to be somewhat supportive for the global leading indicators, which have been improving slightly, notably for Europe, which is more cyclically exposed to China than the US. As such we maintain our probability of 65-70% of a sharp slowdown scenario for the global economy, with only a 30-35% probability of recession. Risk of stagflation for Europe is notably higher in our view, even though the region could be more supported by China’s recovery. On the other hand, it’s important to monitor the banking sector concerns; if it leads to a protracted impact on credit lending conditions, we think the risk of recession becomes higher.
We believe corporate earnings are heading into a recession this year, with further downgrades to estimates across most markets.
In such uncertain environment, we continue to focus on companies that:
(i) have resilient earnings, given risk of further downgrades,
(ii) that have pricing power, given the higher inflation, in order to protect margins;
(iii) that have solid balance sheets in case we head into a recessionary period, and
(iv) that are exposed to structural growth themes, which should sustain their superior growth potential in a lower growth environment we are facing.
Valuation discipline will also continue to be an important focal point, as always, but even more so at this stage in the cycle. Our valuation approach has always assumed a return to a normalised rate environment, even when rates were abnormally low, which means that we have had and continue to have a high hurdle rate when assessing valuation attractiveness in any investment opportunity. We believe that our strategies provide our investors with companies with an attractive growth profile over the medium term which is significantly superior to the index, stronger balance sheets, and superior ROICs which we forecast to continue to improve over time.
We will continue to use this period of volatility to add to our existing holdings and assess the valuations of companies which have been on our watch list.
1 Pernod-ricard: https://www.pernod-ricard.com/en/our-group