US growth stocks unlikely to be troubled by short-term inflation

Taymour Tamaddon July 27, 2021 08:59

Optimism surrounding the nascent U.S. economic recovery following one of the deepest downturns in history has been tempered in recent months by a sharp rise in inflation. Annual consumer price index (CPI) inflation in the U.S. soared to 5.4% in June—well above the Federal Reserve’s 2% target—raising concerns that earlier-than-anticipated policy action might be necessary. This prospect has prompted a rise in equity market volatility, with growth-oriented stocks coming under particular pressure. However, we do not anticipate inflation moving to a consistently higher level over the longer term. As such, we maintain a positive longer-term outlook for growth companies and their ability to grow free cashflows over time.

Inflation Spike Not Expected to Last

The recent surge in U.S. inflation to the highest levels since 2008 is an understandable source of uncertainty for investors who have grown accustomed to the low inflation/low interest rate landscape that has prevailed for two decades. For growth companies, the possibility of rising interest rates has particularly worrying implications as future cash flows will be discounted at a higher rate, impacting company valuations today.

That said, an uptick in inflation was not completely unexpected. This was always a risk once the government and central bank stimulus measures began to flow through to the economy as it progressively reopened for business. Savings levels have risen during the pandemic, and as the rollout of the coronavirus vaccine broadens to a greater proportion of the population, pent-up demand is being released. We expect this higher-trend inflation to continue over the next 12–18 months, before settling back around the Fed’s target 2% level on a longer-term basis. This is in line with what financial markets are currently indicating, with expectations of around 2% CPI inflation similarly being priced in over the longer term.

Expectations for Longer-Term Inflation

Data on inflation expectations appear to support our view that the spike will be temporary. It does not appear that the markets are anticipating a sustained level of higher inflation. The 10-year break-even inflation rate is a direct indication of U.S. inflation expectations over the next 10 years. Despite a steep rise from the lows of early 2020, which initially appears to be a significant shift, the break-even rate has merely moved back up to around 2% expected inflation—well below today’s 5.4% level.

A similar message can be gleaned from the equity market. Given the severity of the market sell-off that occurred in the first quarter of 2020, the U.S. equity recovery has been nothing short of spectacular. While volatility has increased in recent months, the S&P 500 Index is up 14.4% by end June .

Corporate Profits Recovering Strongly

At the corporate level, profits have also recovered well in recent quarters, having fallen sharply during the first quarter of 2020. The recovery has been helped in no small way by the substantial stimulus provided during the past 12 months. Clearly, this level of support cannot continue long term. In the near term, we are anticipating a sharp cyclical recovery in the U.S., with estimated gross domestic product growth of around 6% per annum as the recovery fully takes hold. Such a rapid rate of expansion is not sustainable, but for the next 12–18 months, at least, this potential growth should help underpin the ongoing recovery in corporate profits.

Business Models Will Likely Continue to Prosper

The great rotation trade out of growth stocks into value is playing out in a significant way currently as investors sell out of high-growth stocks in favor of cheaply valued companies, especially those most sensitive to economic recovery. However, at some point, we believe the value reflation trade will play out, and valuations will catch up to long-term averages. With easy returns harder to find, there is every possibility that the appeal of growth stocks, namely the potential to consistently grow free cash flows over time, will reimpose itself once more.

Indeed, there is very little to suggest that the outlook has materially changed for growth-oriented companies. With so many variables, it is impossible to say whether U.S. large-cap growth companies will continue to deliver stellar returns in the next 10 years like they used to in the past decade. However, the underlying business models of these companies have not suddenly become flawed. The qualities that we look for in potential compound growth companies, such as competitive advantage, pricing power, high margins, and dominant positions in large and durable markets, are still very much in evidence.

Take the most successful companies in digital advertising for example. Thanks to rising internet penetration rates and the ever-expanding popularity of digital platforms around the world, digital advertising is fast becoming the most effective and preferred form of advertising. Spending has been growing rapidly and looks set to increase over coming years. Therefore, we expect the established, dominant players in this secular growth area could quite reasonably continue to grow at a faster pace than the market for years to come.

It is also worth highlighting that the onset of the coronavirus pandemic has forced many companies to adapt their businesses, improve operationally, and provide better customer service. In 2020, for example, we saw the widespread adoption of e-commerce as people were forced to shop online. As a result, businesses invested huge sums in streamlining operations and improving logistics in order to provide better experiences for customers. We expect to see more of this reallocation of investment toward e-commerce, as well as digital advertising.

The Appeal of U.S. Growth Companies Is Fundamentally Unchanged

The principal appeal of growth companies is their ability to grow their free cash flow over time. This is an essential feature as it represents the surplus or discretionary cash that a company generates. Over the past decade, the cumulative growth in free cash flows generated by U.S. growth companies has been massive. We believe the inherent, fundamental ability of growth stocks to grow free cash flows over time remains very much intact.

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Taymour Tamaddon

Portfolio Manager, US Large Cap Growth Equity Strategy at T. Rowe Price