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Fidelity - Time to be selective

  • The post-covid market rally was driven by a juxtaposition of ‘reflation’ and ‘stagnation’ narratives that led investors to attribute high valuation premia to ‘growth’ assets, while overlooking the ‘quality’ and ‘value’ style factors.
  • In this environment, investors flocked towards cheap passive funds and were rewarded as market momentum propagated pre-covid market trends and caused intra-market valuation dispersions to reach multi-decade highs.
  • Previously strong-performing passive solutions could face drawdowns if asset valuations are reassessed as central banks act to control inflation. However, such a situation would present active funds with compelling opportunities to generate alpha.



The world is facing a realignment of generational scale and scope. Russia’s invasion of Ukraine has disrupted the global geopolitical order at a time when multi-decade high inflation is already forcing Western policymakers to choose between price stability and economic growth. We have termed this the ‘Reverse Draghi Moment’ and it could spur significant change within asset markets, with central banks likely to validate increasingly hawkish interest rate pricing until inflation momentum turns downward. In this new, rapidly shifting environment, US equity investors can no longer ‘buy the market’ by investing in passive funds; instead, they should take a discerning, active approach when selecting their investments.

United States: the safe(est) haven

During times of uncertainty, investors seek stability. With the world facing systemic challenges associated with Russia’s invasion of Ukraine, broader geopolitical concerns, and the lingering effects of covid, the US economy provides a safe haven. It is relatively insulated from the growth and inflation shocks emanating from the Ukraine conflict and although the Federal Reserve is tightening its monetary policy stance, this is well telegraphed and there are some key tailwinds that should support growth even as it does so.

The US consumer is very healthy, with households having paid down debt and accumulated significant savings through the pandemic, with the help of unprecedented fiscal transfers. As such, consumption, which forms roughly 60% of US GDP, should prove resilient for some time even as prices continue to rise (the average US household will have to spend an estimated $5,200 more this year due to inflation). Likewise, US companies are cash rich and will be able to continue financing investment to meet strong consumption demand, even as borrowing rates rise.

These dynamics have been evident in the recent US corporate earnings season, which showed that many companies are proving able to maintain their profit margins by passing on cost increases on to their customers. This dynamic validates the Federal Reserve’s confidence in its ability to engineer a ‘soft landing’ for the economy via tighter policy and our base case is that the US is heading for a period of stagflation, rather than imminent recession. Under such circumstances, the US dollar could also find further support from widening regional interest rate differentials.

As an asset class, US equities remain well placed in such an environment. This is particularly true for stocks that can generate sufficient earnings growth to offset any downward revision of market valuation multiples resulting from an increase in the risk-free rate. As per our recent equities outlook, we expect US corporate earnings growth to decline from 2021 in 2022 to a respectable level of 7.5%. However, an active approach to stock selection backed by in-depth, bottom-up research should be able to identify companies that can outperform this rate of earnings growth in an environment of slowing growth and rising prices.

From stagnation to stagflation: a style factor shift

While the US economy and its equity markets are relatively well placed on a global basis, the shift to a stagflationary backdrop marks a significant change from the disinflationary, low-rate investment environment of recent years. For the first time in decades, the world’s major central banks are being forced to act to bring runaway inflation under control. As was the case when then-Federal Reserve Chair Volcker hiked rates sharply in the 1980s, this will cause collateral damage in the form of lower economic growth, although the extent of this remains to be seen. Some of the key implications for investors are:

  1. A higher risk-free rate that reduces the current value of future cashflows and weighs down on long-duration asset valuations.
  2. Higher borrowing costs for debt-financed businesses and the threat of higher defaults for money lenders.
  3. Potential revenue pressures due to lower global growth.
  4. Potential margin pressures due to rising input costs (commodity prices, wages, etc.) where these costs cannot be passed on to customers.

Gauging the repercussions of these headwinds for market performance leadership requires an understanding of the current market context. It is no secret that the mega- cap tech companies have been the major winners of recent years, or that the ‘growth’ style factor has sharply outperformed ‘value’ over the past decade. However, in aggregate, the valuation divergence of high-growth and value stocks was not justified by an accompanying divergence in their relative quality (in terms of return on assets or profitability).

Instead, growth’s large outperformance was primarily caused by the juxtaposition of two market narratives that drove momentum during the post-covid market rally. These were:

  1. A ‘stagnation’ narrative that led investors to attribute a multi-decade-high valuation premia to growth businesses in what was perceived to be a scarce-growth, low-rate environment.
  2. A subsequent ‘reflation’ narrative, whereby cyclicals outperformed due to perceptions that they would benefit from economic normalisation after the pandemic.

Nevertheless, the market environment began to shift through 2021. In mid-February 2021, financial conditions started to tighten as it became evident that certain key drivers of US inflationary were strengthening. The effect was first felt in speculative areas of the market, with the Unprofitable Technology Index having since lost half its value. Later, in mid-November 2021, the valuations of growth stocks (long duration) peaked relative to those of dividend stocks (short duration) as rate hikes began being priced into markets more aggressively when it became clear that inflation was proving both higher and more persistent than the Federal Reserve had expected.

Rather than the unprofitable ‘concept’ stocks and low- quality cyclicals that drove the post-covid rally, rational investors are now turning to high-quality businesses with defensive revenue streams and pricing power that will allow them to maintain their operating margins and profitability in a stagflationary environment. Investors must take steps to identify such companies through a discerning, active investment process.

The key question is whether this new dynamic will continue and what it means for investors. It is notable that although the growth style factor outperformed value significantly during the disinflationary, low-rate post-global financial crisis era, value had generally outperformed for most of the post-WWII period beforehand. This is logical, as you would anticipate that the price paid for an asset would have the most significant influence on the returns earned from it.

With nominal risk-free rates now moving well into positive territory, investors are being forced to reassess the low ‘disinflation-era’ cost of holding non-profitable long duration assets. This is causing value to reverse its underperformance of growth. Although the extent of recent market moves might seem dramatic, it is important to note that financial conditions remain very loose by historical standards and could potentially tighten far further if inflation remains resilient. The recent rotation in market performance leadership has only reversed a minor part of value’s underperformance of growth over the past five years and it is therefore logical to deduce that the market leaders of the post-covid rally might continue to underperform if the investment backdrop shifts further towards stagflation. In any case, we believe the discounts of certain quality-growth companies remain at compelling relative levels.

Active management back in fashion

The bull market of recent years saw investors rush into low-cost passive funds to gain their US equity exposures. Until recently, these investors were rewarded as market trends proliferated and companies with large capitalisations grew even larger. However, investors who have maintained passive US equity exposures through the past year will have suffered during the bouts of volatility we have seen, as many of the market’s largest constituents (and therefore their largest underlying investments) have experienced sharp selloffs.

This rollercoaster experience highlights a key problem of passive investing - when markets rise investors profit, but they have no protection from market declines when they occur. As most passive products are weighted by market capitalisation, this inherently overweights expensive assets and underweights cheap assets, irrespective of the justification for any valuation differences. In turn, these distortions expose investors to high concentration risk when asset bubbles form, while causing them to be underexposed to areas of value when market valuations are reassessed.

An example of this is provided by the Dotcom Bubble, during which the Information Technology sector expanded to a peak of over a third of the S&P 500 Index by capitalisation. Passive index investors at the time would have held a third of their investments in expensive technology stocks and would have therefore suffered significant losses when the bubble burst. At that time, a skilled active manager would have recognised and avoided these overvalued stocks, thereby generating significant alpha by limiting drawdown and preserving capital when the sector fell back to just under an eighth of the Index over the subsequent two years later.

Taking a contrarian view that avoids the best performing stocks might not always make sense, but it is equally true that the distortions that momentum-based markets can create will present opportunities when conditions shift. Such opportunity is demonstrated by the relative performance of the equal-weighted and capitalisation-weighted S&P 500 Indices over multiple cycles. Periods where the equal-weighted index is outperforming the capitalisation- weighted index represent times where the average stock is outperforming the Index’s largest counterparts. This is often because market dynamics are shifting away from the factors that gave its largest constituents that status in the first place.

Not all cheap, unloved stocks will necessarily start to outperform when market cycles turn, as some will be cheap for good reason and therefore unlikely to perform well in any market conditions. However, certain stocks will benefit from style shifts when they occur, while others will lose out. A discerning approach is therefore necessary to determine exactly how the investment backdrop is changing and which companies will benefit as a result. Investors looking to benefit from such shifts will have to take an active approach with selective exposures determined based on in-depth research.

Active rather than hybrid

In recent years, the line between active and passive investing has become somewhat blurred due to the proliferation of ‘smart beta’ products. These aim to enhance the returns of traditional passive products via algorithmic adjustments based on quantitative financial datasets, while maintaining their low costs. Research has shown that such strategies have the potential to generate long-term outperformance, but they have not been tested through a period where the market backdrop is undergoing such fundamental adjustment as it is at present.

We believe a fully active approach to investing is more appropriate during such times, as it can account for qualitative factors that algorithmic strategies cannot effectively incorporate. For example, the ability of a company to maintain its pricing power is dependent not only on the company itself, but also its end markets, existing technologies, supply chains, competitors, etc., factors which are all hard to quantify in data.

Another characteristic that is best assessed by active research is sustainability. Rather than relying on the backward-looking data provided by public disclosures, bottom-up researchers can engage with companies to uncover forward-looking information that can not be derived from data analysis, such as regulatory developments. Indeed, our own proprietary ESG Ratings seek to provide a mechanism through which detailed, qualitative sustainability assessments can be integrated into active equity portfolios to mitigate hard-to-quantify ESG risks such as litigation, erosion of brand value, and assets becoming stranded.


Change is often spurred by crisis and at present, the post- covid investment narratives of reflation and stagnation are giving way to fears of stagflation, ‘Volckerism’, and even recession. Exacerbated by concerns around Russia’s invasion of Ukraine, this confluence of headwinds is spurring fundamental change within the investment backdrop. It is no longer appropriate for investors to simply ‘buy the market’ by investing in passive solutions.


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