Key Points
- Slower economic growth and falling bond yields in 2024 could prompt a reappraisal of the relative attractiveness of growth versus income stocks.
- As active income investors, guided by our multidimensional research, we are targeting undervalued quality companies with strong balance sheets, pricing power and the ability to raise dividends.
This time last year, our message was that we did not expect interest rates to come down quickly, as we expected inflation to prove relatively sticky in response to deglobalization, decarbonization and rising wages. We anticipated a relatively favorable backdrop for income stocks in 2023, relative to growth stocks. Certainly, during previous inflationary periods, income stocks have generally proved an attractive proposition for investors looking for inflation protection and defensiveness at a reasonable price.
Market Leadership
One year later, interest rates have risen further, and inflation remains an issue, being still some way from central bank targets despite recent moderations in price rises. Surprisingly, against this backdrop, we have seen a reassertion in leadership from growth stocks. In 2023, market leadership has reversed and 2022’s biggest laggards – the communication services, consumer discretionary and technology sectors – have been the strongest performers so far this year.* This outperformance has been driven by a narrow group of growth companies.
So why haven’t growth stocks derated in the face of a higher discount rate? The reason is in part the excitement there has been around generative artificial intelligence (AI), but also the fact that economies have remained robust, which has kept employment high and boosted pension plan contributions into passive strategies that systematically buy those largest companies.
Looking ahead, while it is possible that market leadership remains concentrated in large technology stocks that do not meet our strict yield criteria, this is not our expectation. Should economic growth slow in 2024 as we expect, the valuation risk in these businesses will start to become more apparent, particularly as rising unemployment begins to reduce the flows into pension plans. Looking at the valuations of many of the large technology stocks, we believe they are eerily reminiscent of the technology boom in the late 1990s and early 2000, ahead of the bursting of the Nasdaq bubble.
In 2023, rising bond yields have reduced the relative attractiveness of higher-yielding equities, hence the year-to-date underperformance of the consumer staples, health care and utilities sectors. But 2024 could be a better year for income stocks versus growth stocks, with the catalyst being slower economic growth. Falling bond yields could prompt a reappraisal of the relative attractiveness of the consumer staples, health care and utilities sectors.
Income Opportunities
Although the outlook for dividends will not be universally positive if growth slows, there should be investment opportunities, particularly among companies with such strong market positions that they have the ability to raise prices in excess of rising costs, or the ability to raise prices even if their costs fall.
Many innovative health-care companies have pricing power, as do many consumer-staples companies with strong well-invested brands, not to mention various regulated utilities. There are also opportunities in defensive financials, specifically exchange-volatility plays and insurers. Insurance companies are continuing to raise prices, and the costs for some are starting to deflate, which augurs well for dividends.
Elsewhere, the energy transition could be an interesting theme in 2024. In the short term, momentum appears to be stalling as some governments are seemingly pulling back. We are hopeful that this reduced support and slower economic growth could create investment opportunities in industrial companies exposed to the theme.
Turning to Newton’s key investment themes, arguably the most pertinent macro theme is ‘great power competition’/geopolitical risk and governments playing a more direct role in economies. There is no sign of geopolitical tension abating, and that is likely to be inflationary because it results in higher levels of protectionism, localization of manufacturing, and defense spending.
Our key message is that our global income portfolios are positioned for an environment of slower economic growth, with the key overweight sector positions being consumer staples, health care and utilities, balanced with an overweight in defensive financials. Aside from technology, the other key underweight sector exposures are commodities, real estate, consumer discretionary, and industrials, which are the more cyclical parts of the market and the areas in which dividends are most at risk from slowing growth. As active income investors, guided by our multidimensional research, our focus is firmly on undervalued quality companies with strong balance sheets, pricing power and the ability to raise dividends.
* FTSE World, as at 10/31/23.
Authors
Jon Bell
Portfolio manager, Equity Income team
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