Markets have been exceptionally volatile since mid-November, as investors have digested the impacts of rising inflation, pending US Federal Reserve actions, the potential end of the COVID-19 crisis, and the tragic situation in Ukraine. Rising interest rates have reduced what investors are willing to pay for growth and “cash-in-the-future” businesses, and may increase the risk of recession amid the inflationary backdrop of rapidly climbing fuel and food prices.
Even though rising rates reduce what investors are willing to pay for higher-growth companies, they are also usually indicative of a strong or improving economic backdrop, which tends to be good for more economically sensitive small- and mid-capitalization (mid-cap) businesses. Economic conditions appear robust in the United States and Europe, but inflation is also robust. As central banks increase rates to rein in inflation, there is risk that economic activity loses momentum and serves as a moderate headwind to the near-term growth prospects of less-diversified small- and mid-cap companies. Investors have anticipated this, which has driven equity valuations down meaningfully.
In our strategy, we tend to emphasize higher-growth small and mid-cap companies, which are earlier in their journey toward profitability. These factors have been out of favor for the past few months, and, unfortunately, the indiscriminate selloff has not taken solid individual company fundamentals into account, in our view.
We believe that well-capitalized, cash-consuming companies with strong unit economics (revenues and costs in relation to an individual unit) and leading positions in large and secular growth markets can be excellent businesses under any kind of interest-rate scenario. In volatile periods like the one we find ourselves in today, companies with these attributes can leverage their leading position and easier access to capital to consolidate market share and pull ahead of their capital-constrained peers. We are long-term, growth-oriented investors with quality at the center of our process. As we have seen superior businesses with attractive long-term prospects—some with cash-consuming profiles—sell off, we have been taking advantage of what we consider improved valuations to add to our positions.
Impact of Russia-Ukraine War on Europe and China
We pay close attention to where companies generate their revenues to understand their short- and long-term prospects. Given Russia’s actions in Ukraine, we believe the risk of recession is on the rise in Europe, which makes us more cautious toward companies with higher European exposure. China’s increasingly stringent and opaque regulatory regime has also kept us from investing in the country. Conversely, we have greater confidence in companies with higher leverage to the US economy. We have also been focused on higher-growth emerging markets throughout Asia.
We anticipate a modest near-term impact to the production of semiconductors and technology hardware that requires nickel and titanium, along with semiconductor-grade gases (neon, xenon, argon and krypton), which are sourced partly from Ukraine. Importantly, our research indicates that there are significant buffer inventories of these critical materials around the world, which we believe can last for at least six to 12 months. In addition, previous efforts were made in the wake of Russia’s 2014 annexation of Crimea to find new sources of neon (used in silicon chip lithography) outside of Ukraine. That said, as semiconductors are essential enablers of our digital lives, a prolonged supply disruption would likely present a revenue and/or cost headwind for the broader “Digital Transformation” opportunity. We believe the challenges would be most acute the closer a vendor is to the direct inclusion of semiconductors in its products.
Growth Sector Outlook
As long-term investors, we don’t strive to make short-term trading decisions at the sector or style level. The case for investing in technology companies is compelling, in our view, regardless of where we find ourselves in the economic cycle. Enterprises and consumers invest in technology to drive better productivity. We think enterprises are most willing to accelerate their investment in technology when they see their own prospects improving. The inverse is also true. In addition, if inflation headwinds persist on the labor side of the market, we believe enterprises will look to technology and business process improvements to better manage their costs. Such investments would be a tailwind for our “Digital Transformation” thesis, which could help to offset recessionary headwinds.
Longer term, we see significant opportunities across a range of themes, which range from artificial intelligence (AI), machine learning and analytics to new commerce and digital customer engagement, to cyber security, electrification, autonomous technology (enriching automated systems with sensors, AI and analytical capabilities), and more. While all these opportunities are compelling, we believe the secure cloud and SaaS (software as a service) theme represents the largest opportunity as it underlies all other digitization trends. None of the other themes are possible without the cloud. We are also excited about digital media transformation and the rise of the metaverse (a fully realized digital world). We believe the metaverse opportunity may represent the ultimate “Digital Transformation” application.
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments.
Past performance does not guarantee future results.
Important Legal Information
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.
Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.