Growth Stocks: Attractive Prospects in 2H 2023 but Selectivity is Key

Matt Freund, CFA, Michael Kassab, CFA

• Markets may advance at a slower pace in the coming quarters, but we see solid growth prospects for many companies supported by secular themes.
• Although the rally may slow, we expect leadership will broaden beyond the “Magnificent Seven” of mega-cap stocks, rewarding a broader group of companies with consistent cash flow generation and strong balance sheets.
• Semiconductor, cloud infrastructure, and software stocks have been the primary beneficiaries of “AI euphoria” but the ultimate winners will likely include a wide array of businesses across many sectors.

Growth stocks continued their strong recovery in the second quarter. With lingering concerns about the economic impact of higher interest rates and tighter lending standards following the March bank failures, investors gravitated toward the relative safety of mega-cap companies with reliable growth profiles and fully funded capital needs. Against this backdrop, the largest seven market-cap companies in the S&P 500 Index (often called the “Magnificent Seven”) accounted for 80% of the index’s year-to-date gains.

The economy has remained surprisingly resilient throughout the Federal Reserve’s aggressive rate hike cycle, which may finally be close to its conclusion. Fears of a significant slowdown in bank lending have mostly faded and the much-anticipated recession continues to get pushed out. While the lagged effects of higher rates may weigh on growth in 2024, employment data is holding remarkably steady with historically low layoffs and consumer spending remains healthy. Americans of all income levels continue to play “catch-up” on the activities they skipped during the pandemic lockdowns, including family vacations, concerts, and dining out.

As we look ahead, we see reason for caution given economic uncertainties and believe the broad markets may find it difficult to repeat the first half’s strong performance. At the same time, we see opportunities for continued strength in certain investment themes. One of the true bright spots the past few months has been the growth of artificial intelligence (“AI”). Although AI has been around for years, it reached an inflection point in early 2023, when a new application brought the technology to the mass market along with the stunning realization of its capabilities—AI could not only answer questions, but also write literature and create images.

Investing in companies at the forefront of innovation can be highly rewarding but extremely volatile. We have significant positions in strong technology companies that are now viewed as key AI players. There is little doubt that artificial intelligence has the potential to be game-changing for the global economy, in much the same way that the internet has been over the past 20 years. But as we learned through those early days of the internet, the list of potential winners and losers can change frequently and rather abruptly.

Semiconductor, cloud infrastructure, and software stocks have been the primary beneficiaries of the “AI euphoria” so far. However, the ultimate winners will likely include a wide array of businesses across many sectors. At the current pace of development, artificial intelligence could soon be deployed by companies both large and small to make their workforces much more efficient by automating everyday tasks and streamlining more complex processes. This, in turn, may help rationalize workforces and benefit cost structures, but at a potentially high cost to society overall. Time will tell how this all plays out.

Although the broad equity market may see more modest gains in the second half, we believe active management with a discipled risk-management approach will prove beneficial. We expect the current market run to broaden beyond the Magnificent Seven but will continue to reward companies with consistent cash flow generation and strong balance sheets. This group of growth-oriented companies may prove to be more “defensive” than the traditionally defensive segments of the market (i.e. consumer staples and utilities) that are richly priced and may not provide the protection that investors expect. As always, we remain committed to a selective and thoughtful approach as we sort through the next exciting phase of technological innovation.