Market Review
Once again, the environment during the quarter can be characterized as challenging and tumultuous. Ongoing uncertainty around the outlook for interest rates, inflation and earnings, coupled with two of the top 15 US banks failing, led to extreme volatility. Investors reacted violently to macro data points leading to several sentiment-driven reversals during the quarter. Market gains can be attributed primarily to price-to-earnings (P/E) multiple expansion.
As was experienced through much of 2022, each time there is a belief the U.S. Federal Reserve (the “Fed”) may pivot policy, it catalyzes a short-term, high-beta rally. The Fed has indicated no intention to cut interest rates this year, yet the first part of the quarter was characterized by a risk-on, re-rating rally in which high-beta, low-quality stocks outperformed. The worst performing stocks of 2022 were the strongest performers during the quarter, driven by mean reversion and short covering. This rally was, once again, indiscriminate of fundamentals and a headwind for portfolio performance. Most of the portfolio underperformance in the quarter can be attributed to not keeping up during this risk-on rally.
Sentiment then shifted midquarter. The failure of Silicon Valley Bancorp and Signature Bank raised fears of a potential global banking crisis. While each bank had idiosyncratic issues, the market began to worry about duration risk at other financial institutions and a potential tightening of credit standards. This caused a selloff in risk assets and a flight to safety toward companies with strong balance sheets that are unlikely to have the need to access capital markets. This in turn benefited many large-cap technology companies, which tend to have strong cash flows. In addition, the fear of contagion coupled with weakening macroeconomic data led the market to believe the Fed might cut rates this year. This catalyzed further P/E multiple expansion in some of the mega-cap technology names. Concerns over access to capital and near-term cyclical weakness led to a rotation out of industrials and materials despite the strengthening long-term outlook. Portfolio holdings within these sectors underperformed in the quarter, contributing to negative excess returns.
U.S. Growth stocks, represented by the Russell 1000 Growth Index (C$), gained 14.2% in the quarter, but market leadership was narrow. Within that index, six stocks that account for about 39% of the index by weight (Apple, Microsoft, NVIDIA, Tesla, Amazon and Alphabet), drove 70% of the overall return. Most of the gains witnessed during the quarter were due to P/E multiple expansion. Interestingly, many stocks whose earnings have been revised lower, outperformed during the quarter. For example, during the quarter, earnings estimates for Tesla were revised down 3% to 5%, yet the stock gained 68%, rebounding from a sharp Q4 selloff driven by multiple expansion. Apple gained 27% during the quarter, and because of its outsized weight in the index, contributed about 21% of the overall index return. These types of dislocations between stock price performance and earnings are, in the sub-advisor’s (MFS Investment Management) opinion, not sustainable over the long term.
The Sun Life MFS U.S. Growth Fund (the “Fund”) outperformed its benchmark, the Russell 1000 Index (C$) over the quarter.
- An overweight in Information Technology, the strongest-performing sector in the benchmark, contributed to relative performance. This was offset somewhat by stock selection in that sector, primarily due to the underweight in Apple.
- A combination of both stock selection and an underweight position in Financials, a weaker-performing sector in the benchmark, also contributed to relative performance.
- Stock selection in Health Care contributed to relative performance, including not owning high-benchmark-weight Abbvie, Merck and Eli Lilly, which were detractors last year.
- Stock selection in Materials detracted from relative performance primarily due to positions in Air Products and Vulcan Materials, which were weak due to short-term cyclical concerns.
- Stock selection in Communication Services and Industrials also detracted from relative performance.
While the Fund outperformed its benchmark over the period, index concentration and a lack of breadth in index returns were headwinds for the portfolio in the quarter. As discussed in greater detail in the Market Review section above, six names totaling about 39% of the Russell 1000 Growth Index drove 70% of that index’s return. The lack of breadth was driven largely by increased volatility and uncertainty around macro events. MFS remains committed to building a diversified portfolio of higher-quality, long-duration growth companies trading at sensible valuations.
Manager Outlook
Looking ahead, MFS expects the market to remain choppy. In the short run, market volatility is expected to be dominated by macroeconomic events, but uncertainty over long-term earnings continues to grow. We have just witnessed the fastest pace of rate hikes in history after a decade of unprecedented monetary and fiscal stimulus that was tailwind for equities. These trends were not sustainable, and MFS believes the end of the “growth at all costs” era is healthy for the equity markets as companies focus on profitable growth in more rational markets.
However, MFS believes it will take time to see the impact of rising rates and inflation on the economy and earnings. There were some unintended consequences in the banking sector this quarter, but MFS doesn’t know what other potential impacts may arise in the future. Companies continue to face downward earnings risk due to weakening demand and higher input costs. While aggregate estimates have moved lower, they do not appear to fully reflect the deteriorating macro environment. MFS doesn’t attempt to be experts at forecasting inflation trends or interest rates, but they are diligent in evaluating company fundamentals and earnings. MFS believes it is their job to look through the short-term volatility and stay focused on their process of identifying high-quality companies that can generate consistent, above-average rates and duration of growth despite the weakening global economic outlook. MFS has started to see wider dispersion in earnings results by company and they expect these trends to continue. In an environment where aggregate earnings are at risk and there is a scarcity of earnings growth, stock selection becomes even more important. Typically, highly visible, durable growth should be rewarded.
MFS spends a lot of time searching for industries with secular growth as well as trying to identify changes in the trajectory of secular growth, both positive and negative. They believe many of the secular growth drivers that enabled the technology sector to lead market returns over the past five years have reached higher penetration rates and are maturing. As a result, while these companies may continue to post above average rates of growth, they will most likely slow and will be less outsized relative to the rest of the market. As market trends normalize and focus shifts to earnings rather than central bank policy, they believe market leadership will transition from the highly concentrated group of mega-cap stocks to be more evenly distributed amongst companies poised to benefit from the next cycle of both secular growth and capital investment.
Other forces that have been positive trends for businesses may also be reversing. Globalization, for example, has been reversing as companies recognize the negative impacts of multiple geopolitical risks. Companies have indicated the need to move manufacturing and supply chains to safer environments. In addition, companies have underinvested in capital expenditure (capex) for decades and there is room for capex to grow as a percent of cash flow. Other trends that could spur new investment include the demand for clean energy, energy efficiency, industrial automation, electrification, and infrastructure. While many of the companies benefiting from these shifts in secular demand are subject to short-term, cyclical weakness, MFS believes these global trends could force companies to focus on previously underinvested areas, supporting longer-duration revenue and earnings growth for a new set of leaders.
The sub-advisor has not changed their investment process and maintains a focus on high-quality companies that they feel can maintain above average durations of and rates of growth over a full market cycle. MFS’ strategy focuses on companies with exposure to strong secular growth trends, durable competitive advantages, high barriers to entry, pricing power and strong management teams.
