But the tailwinds from 2021 are now driving headwinds as inflation increases and the US Federal Reserve begins to taper bond purchases in 2022, raising interest rates. Notably, we believe the market will price in more persistent inflation, which hit a 30-year high in September. We expect economic growth to slow in the first half of 2022 as higher prices for energy and other goods weigh on consumer confidence and squeeze real incomes unless wages rise enough to support reflation.
In our view, it is crucial to next consider how different growth companies behave amid these diverse factors.
Rising rates’ impact on growth
The effect of rising rates varies significantly across companies and sectors. On the positive side, high-quality growth financials can benefit from exposure to wider interest-rate spreads. For example, wealth management companies can charge higher fees on cash balances, banks’ net interest margins should expand as rates go up, and demand continues to increase for private equity investments that are uncorrelated with public equities.
On the other hand, when interest rates rise, valuation discipline becomes even more important, in our view. This is particularly true when investing in growth equities. Higher rates impact more expensive, higher multiple stocks as their cost of capital rises. For instance, we see examples of this among some tech stocks. This is one reason why valuation discipline is an essential input into our process. We look for stocks to have a minimum of 10% valuation upside potential and also seek to avoid exaggerated free-cash-flow yield valuation multiples. In addition, companies with more balance-sheet leverage and emerging markets countries with high levels of dollar-denominated debt can struggle in a higher-interest-rate environment. Our focus on high-quality companies generating strong free-cash-flow margins with low debt levels is therefore especially important in this environment.
Growth companies amid inflation
Similarly, the impacts of inflationary pressures range widely across companies and sectors. Some can absorb higher cost inputs without sacrificing margins because they have the pricing power to pass these costs on to their customers. Such companies exist in the software and services, health care, data analytics, and industrials sectors. In our view, these businesses are attractive in this environment as they have pricing power because their products and services are unique and high value, improve efficiency, lower costs, and are mission critical for their customers.
Conversely, companies that sell products that are less differentiated or lower value-add may lack pricing power, particularly given the price transparency available online. For example, consumer staples companies are more vulnerable to today’s rising inflationary pressures. These companies absorb higher raw material and transportation costs without fully passing these costs on to their customers, resulting in lower margins. Wage inflation also puts margin pressure on companies with high labor costs, such as those in the consumer services or consulting sectors. Notably, leading companies with global scale are less susceptible to wage inflation as they have better technology platforms to hire and train people and recruit from different countries, which is more difficult for smaller companies.
Growth opportunities in China
Lastly, we believe China offers strong economic growth potential and investment opportunities in 2022. The country tightened liquidity with increased regulations during 2021. As a result, China’s increase in economic growth was low relative to other major countries, and its equities lagged. However, we believe China now offers investment opportunities as we expect the government to stimulate the economy in 2022 as the rest of the world tightens. Further, we anticipate that China’s regulatory activity will slow and believe the country’s stocks trade at attractive valuations today.
In particular, we like consumer, internet, and health care companies in China as we think these sectors benefit from secular government support for growth as well as an emerging middle class with discretionary income to spend on goods and services.
Today’s markets are influenced by strong macroeconomic forces, including government stimulus, rising interest rates, inflation, and regulation. As growth equity investors, we find it easier to navigate this volatile environment by adhering to our disciplined, structured philosophy and process. Looking to 2022 and beyond, we believe this approach to identifying companies with high quality, growth potential, valuation upside, and capital return to shareholders is especially important in this market.