Quality Growth Holds Its Appeal as Economic Pressures Mount

Matt Freund, CFA, Michael Kassab, CFA

We believe:

• Mixed economic signals warrant vigilance.
• Companies with exemplary balance sheets and attractive cash flows offer the best prospects for near-term outperformance.
• We see long term upside in AI and the benefits it can bring to a vast array of businesses.

The third quarter started off with significant momentum. The economy had managed to digest the earlier banking disruptions without a hitch, the consumer was still spending at a healthy pace, and energy prices were well behaved. Stocks across all sectors generally rose through the end of July.

That optimism quickly faded as a growing list of concerns came into focus. Energy prices began a steady climb and are now once again approaching $95 a barrel. Interest rates have become increasingly problematic (despite the Fed pause) as 10-year Treasury rates rose to levels not seen since the 2008 recession. At the same time, the market is growing increasingly concerned about the outlook for corporate earnings (which were expected to show significant growth in the second half of the year) as higher rates, labor costs, a stronger dollar, and weakening consumer expectations become more widespread.

Our confidence in “fortress” growth stocks persists although many gave back some of their strong gains in the third quarter. Importantly, within the US equity market, as measured by the S&P 500 Index, there were only two positive sectors in the quarter (energy and communication services), while traditionally defensive sectors, like utilities and consumer staples, underperformed. Smaller companies fared even worse.

The economy continues to flash mixed signals. The current trend of positive but tepid growth will likely continue for the next couple of quarters. However, a surprising number of factors are pointing toward further softening: the inverted yield curve, tighter lending standards, higher energy costs, increasing labor costs, and higher financing costs. These all add up to growing profit pressures on the private sector. In addition, the rest of the world remains weaker than the United States and, therefore, unlikely to provide a boost to domestic growth.

In an environment where growth may prove increasingly scarce, we believe asset-light companies with the flexibility and financial strength to continue funding their growth initiatives—regardless of the economic backdrop—should be able to outperform. As a result, we continue to favor quality growth companies with stellar balance sheets and attractive free cash flows. We believe these companies are better positioned to capitalize on the opportunities that volatile markets provide, as seen in the largest companies’ first-mover advantage of AI. On the other end of the spectrum, we are increasingly cautious about the outlook for unprofitable technology companies.

Although some of the euphoria surrounding AI stocks has abated in recent weeks, we have maintained considerable exposure to this investment theme through our positioning in semiconductor, cloud infrastructure, and software stocks. Undoubtedly, investor enthusiasm around AI will ebb and flow over time, but we remain confident this technology will bring new applications and widespread benefits to a vast range of businesses beyond the technology sector. As always, we remain committed to a selective and thoughtful approach as we sort through what lies ahead for this exciting innovation.