More focus on quality firms key in slowing economy

Oksana Patron

9 December 2022

A slowing economy with falling inflation will see the quality factor come to the fore next year, as companies with strong balance sheets typically outperform in a late cycle environment, according to VanEck.

Cameron McCormack, VanEck’s portfolio manager, noted that a US recession was priced as a probable scenario in late 2023, given the rapid succession of central bank policy rate hikes and the Fed’s apparent commitment to curb inflation.

“We believe the ‘quality’ factor will be dominant and over the long term, persistent across the cycle,” he said.

“US headline and core inflation have started to fall but services inflation remains sticky. Services inflation contributes 60% to total CPI and high accelerating year-on-year growth is a function of high wage growth and record low unemployment. US ISM Services PMI print for November this week came in much higher than expected at 56.5, further illustrating the tight labour market.

“Historically though, every time the US unemployment rate has increased by more than 0.50%, it has resulted in a recession.”

The manager said that quality companies typically traded at a valuation premium relative to the benchmark, i.e. price to earnings (P/E) meaning that prices were more sensitive to interest rate movements so if treasury yields came off, this would present a tailwind for quality companies due to their longer duration exposure.

McCormack noted that with stable earnings, quality companies typically outperformed in a late cycle environment as they were rewarded for their ability to generate sustainable earnings amid a backdrop of stagnate economic growth.

Following this, VanEck’s quality exchange traded fund (ETF) (QUAL) saw decreased weighting to information technology companies in the aftermath of mixed results during the Q3 US earnings.

“Netflix was removed from the portfolio as new subscriptions stagnated and competition in online streaming services heats up. Its earnings per share (EPS) has fallen 12.5% this year.

“US home improvement retail store Home Depot was added to the portfolio following improvements in its return on equity and earnings variability. The stock’s P/E multiple is at its lowest level since mid-2019 despite emerging from the pandemic a structurally stronger business with expanding market share.

“Quality was the standout factor between the global financial crisis and emergence of COVID-19 during an era of falling inflation and stagnate economic growth. The stage is set for a repeat of this environment in 2023 and we expect the quality factor to outperform,” McCormack said.