Wellington Management：US Market Outlook—Navigate through Opportunities and Risks

On September 24, 2022, Wellington Management was invited to participate in the Fortune Investment Strategy meeting. Wellington’s Investment Strategist Jeremy Butterworth shared US market outlook—Navigate through Opportunitiesand Risks.

The current CPI of U.S. inflation has over the last 75 years or so. Inflation has roared back after extraordinarily low period. To tamp-down inflation, central banks have been hiking interest rates. That naturally slows economic growth prospects. Additionally, investors consider rates when estimating the cost of capital and the discounted value of future earnings, which is part of what triggered the stock market correction we saw in 2022.

What next? We think it's important to have a forward-looking view. We anticipate that inflation will slow from here. Some of the reasons relate to slowing demand (given rising rates, etc.) but improving supply chain conditions and other factors are also set to moderate in our view.

In the longer-term, workforce development, flexible work arrangements, childcare, and other benefits are also likely to be part of the solution, helping to raise labor force participation rates. Boosting immigration and automating labor-intensive industries will also help these inflationary pressures in markets like the U.S. over the long-term as well

Technology is a wide and varied space regarding fundamentals, shorter-term growth trajectory, and valuations. A meaningful portion of these companies has repriced significantly, disproportionately reflecting the broader subdued growth outlook and interest rate cycle trajectory, especially in the U.S. Historically, technology companies have been considered longer-duration assets, and the cash flows of these businesses are further out in time.

With interest rates rising, future cash flow value would be lower today. We believe it is important to understand which factors are shorter-term catalysts and which ones are the positive catalysts that helps the business to grow their earnings and have meaningful total addressable markets. Therefore, we continue to see some businesses grow at a meaningful pace and have repriced significantly. For example, large cloud enablers will continue to see consistent demand because they drive organizational productivity efficiencies. As a result, this one area corporates are continuing to be willing to spend. On the flip side, the jury is still out on longer-dated, unproven technology business models, where there is less clarity on future cashflows – think consumer space travel and 3D printing.

It’s not much about small vs. large caps; it's more about focusing on the fundamentals of companies with a deeper competitive moat, a lower probability of substitution, and a lower elasticity of demand. And so, we're focused on analyzing and understanding these businesses' quality and ability to manage these challenges. I think technology continues to be an area with abundant opportunities.

Healthcare is also an area we think is an exciting area for investment, especially in the U.S. These companies are driving innovation and are high-quality compounders with strong capital returns to shareholders.

We are witnessing more evolution in the innovation of novel medicine development. And this will drive continued growth in revenues for these companies as they address large and growing patient populations for critical medicines; this could be in degenerative disorders like Alzheimer's or genetic disorders like cystic fibrosis, or even areas like immune-oncology. These leading-edge, large, mid, or small-cap U.S. companies are at the forefront of innovation and change, which will drive continued earnings growth and the opportunity to rerate these companies.

While it is not our base case, a deeper and more protracted recessionary environment is a tail risk we are watching; the strength of the consumer is important for economic success in the economy; they are 2/3 of the contribution to economic output, especially in the U.S.

Additionally, we should watch the U.S. housing market and its potential pitfalls. Housing valuations are usually a significant factor in household wealth, i.e., when your house price is going up, consumers' sentiment is generally stronger and willing to spend and go on holidays. While we see housing valuations moderate, we don't see it taking an about turn in a meaningful way. The current supply, new house formation, and level of new construction vs. demand are still imbalanced. Thus, while we are watching this again as a tail risk, we think this is less of immediate concern.

Outside of the U.S., we also need to be conscious of tensions around geopolitical risks and a misstep from central banks. I think the market has digested several of these risks, but they can still have the meaningful capacity to affect asset prices and shorter-term valuations.

A moderation in inflation and any indication from the federal reserve of a tempering rate trajectory will benefit risk assets. The reason for this is that as we see more inflation moderate, it gives central banks around the world, especially in the U.S., greater bandwidth to loosen their monetary policy and potentially a tempering of the interest rate to our trajectory.

Additionally, an easing of food prices, energy inflation, and any easing of cross-currents from the Ukraine/Russia conflict would also benefit risk assets. That, coupled with the earnings quality of companies surprising to the upside, are key catalysts to generate a rerating in risk sentiment.

We are in a period of heightened volatility and shorter-term thinking market participants. We are moving into a slower growth environment, which will create greater dispersion between companies, industries, and countries. In this current environment, being active investors and allocating capital prudently allow us to drive greater alpha. We think investors should focus on quality, consistent earnings, and EPS growth.