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The dramatic economic conditions of the past couple of years now reward different corporate attributes, says Kathrin Forrest, equity investment specialist with Capital Group.

While market watchers have widely commented on an apparent shift from growth to value, Forrest said that doesn’t tell the full story.

She and her colleagues at Capital Group have identified five major economic shifts. The most apparent is the shift from low interest rates to rising rates and sticky inflation. But markets are also dealing with shifts from multiples expansion to earnings growth, from narrow to broader leadership, from digital to physical assets, and from efficiency to resilience.

“When we put all this together, it really does look like a new reality that’s more nuanced than just a differentiation between growth and value,” she said.

In the face of those shifts, Forrest said investors would be well advised to seek out companies with greater financial flexibility — attributes like strong balance sheets, free cash flow generation, sound capital allocation, and, combined with that, resilient and growing end markets.

Cost of borrowing

According to Forrest, the global rise of interest rates is a key contributor to this new economic climate.

“Money isn’t free anymore and capital is not as readily available,” she said. “So, companies may have less flexibility to refinance or fund future growth. At the extreme, they may even struggle to remain viable.”

The end of cheap money will push a larger portion of corporate earnings into debt service, she predicted, putting additional pressure on profitability and playing into the hands of companies with strong pricing power.

“Dependable cash flows may look attractive in a higher-inflation, higher-cost-of-capital world, as may companies that have the ability to fund their own future growth,” she said.

Broader leadership

According to Forrest, markets are unlikely to continue to be dominated by a handful of U.S. tech stocks that investors have to own in order to keep up. Rather, opportunities will arise for well-managed companies, in a much wider variety of industries and geographies, to shine.

Most notably, the narrow band of tech leaders will be challenged to prove more immediate returns rather than future revenue.

“Interest rates are no longer declining,” she said. “So, with that, returns will not so much come from P/E or multiple expansion but from ‘E’ or earnings expansion.”

In addition, the familiar names in U.S. tech increasingly find themselves competing with each other for future growth opportunities, investment and even advertising revenue.

“It has become a lot trickier for those companies,” she said.

Forrest pointed out that new opportunities have been emerging in a variety of geographies and sectors, including Brazilian materials, U.K. industrials, Hong Kong consumer goods, U.S. healthcare and bio-pharmaceuticals.

“There are a number of companies that are well capitalized, have pricing power and have resilient demand, so there’s near-term visibility into earnings,” she said. “In certain cases, they also have strong cash positions. That puts them in a position where they can fund future growth opportunities, either through M&A or through investing in their pipelines.”

E-commerce challenges

The move from digital to physical assets has been particularly painful for mass e-tailers, she said.

While internet companies saw strong growth during Covid lockdowns, current economic conditions may take some of those gains back. And with demand normalizing, e-retailers may become victims of their own high-capacity, high-cost structures.

“E-commerce companies really have gone from being the disrupters to now being challenged themselves,” she said.

Forrest said some have had to prop up their stock prices with staff layoffs and subscription price hikes, and the responses may become more aggressive if consumer sales slump further.

Global reconfiguration

Forrest said the decades-long trend of creating global supply chains is reversing, as companies shift manufacturing closer to home for geopolitical and pandemic-related reasons.

“This shift is putting a focus on resilience over efficiency,” she said.

Some companies will face the headwinds of higher inventory costs and reduced scale, but the trend also brings tailwinds and opportunities.

“There are some mitigating factors in terms of desynchronized economic cycles and maybe some opportunities with regard to revenues coming from services,” she said, not to mention longer-term structural opportunities.

The bottom line, she said, is that investors must be flexible in strategy and objective.

“The combination of declining interest rates and rising multiples was a really helpful tailwind for equities over the last 10-plus years. It’s possible we will return to that comfortable environment we got used to. But I’m not sure it will play out that way,” she said. “The good news is that it opens up a much broader opportunity set. And we can find companies that have an opportunity to grow earnings across industries and geographies.”


This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.

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