The first half of 2022 was a difficult period for the market, which has been reacting to higher interest rates and the near-term likelihood of economic weakness and lower earnings.
So far, many indicators of economic activity have generally looked good. Unemployment has been low, home prices have been rising, and industrial production hasn’t slowed.
In addition, corporate earnings have remained resilient. The current consensus of earnings growth is 10.6% for this year and 9.2% in 2023. But the market focuses on leading indicators, and those are flashing yellow and, in some cases, even red.
In fact, some signs suggest that the economy may be heading toward recession. According to the University of Michigan consumer sentiment index, consumer confidence is at an all-time low, due largely to inflation, which has reached levels not seen since the 1980s. Because consumers are paying higher prices, they are buying fewer items. In addition, there are signs that the housing market is softening. A slowdown in housing could have a far-reaching impact on economic growth, and while unemployment rates remain low, there has been a recent uptick in layoffs. Initial unemployment claims have been inching up and at 231,000 as of June 30, 2022, they are about 40% above the low level hit in the Spring. When weekly claims reach 400,000, that suggests a recession is ahead. We’re still a long way from that, but the numbers bear watching.
In the first half of 2022, the S&P 500 Total Return (TR) dropped 19.96%. The index entered a bear market on June 13, when it declined 20% from its previous peak of 4797, which it reached on January 3. In the second quarter, the S&P 500 TR declined 16.10%, the Dow Jones Industrial Average TR fell 10.78%, and the Bloomberg Barclays U.S. Government/ Credit Bond Index dropped 5.03%.
Future Outlook
For the economy to flourish in the long term, the Federal Reserve (Fed) needs to get inflation under control. The current inflationary pressures have been caused by multiple factors. Demand, which was overheating thanks to massive fiscal and monetary stimulus during the pandemic, is one. Supply constraints caused by Covid shutdowns in China and labor shortages in the U.S. have also pushed inflation higher.
Higher inflation erodes purchasing power and leads to higher interest rates which chokes off borrowing, resulting in an economy that struggles to grow. In addition, rapidly rising prices have the greatest impact on low-wage earners, who often spend more of their income on necessities. But when inflation is low, interest rates stay low. This encourages companies to fund growth through borrowing and allows consumers to afford loans more easily for homes, cars, and other big-ticket items. Growing companies and growing consumer demand lead to job growth and income growth, resulting in a virtuous cycle.
The Fed is determined to bring inflation back to 2%, and it plans to do so by raising interest rates to temporarily slow demand. The Fed understands that there will be short-term pain because of higher interest rates and that its actions risk causing a recession. But it is committed to putting the economy back on a more sustainable, long-term growth footing. However, we are watching for signs of weakening. In an economic downturn, earnings estimates will almost certainly be reduced. The decline in stock prices is the market’s way of anticipating the possibility of lower corporate earnings.
A positive long-term outlook depends primarily on slowing inflation. Should inflation recede and interest rates decline, the economy and markets will begin another cycle of growth. And as Covid recedes, we expect that China will reopen its economy and that supplies of goods will return to normal, further easing inflationary pressures.
Performance Review
In the first half of 2022, the Mairs & Power Growth Fund fell 21.69%, compared to declines of 19.69% for the S&P 500 Total Return (TR) and 19.25% for its peer group as measured by the Morningstar U.S. Fund Large Blend. In the second quarter of 2022, the Fund fell 15.54%, the S&P 500 TR lost 16.10%, and the Morningstar peer group dropped 14.89%.
Overall, sector allocation had little effect on the Fund’s relative performance in the first half. Positive contributions from overweighting Healthcare and Industrials, along with an underweight in Consumer Discretionary, were offset by lack of exposure to Energy.
Energy makes up only 4.4% of the S&P 500 benchmark, but in the first half it was the best-performing sector by far, up 31.8%. We expect that in the longer term, Energy demand and supply will converge. As a result, price increases should slow, and the portfolio should benefit.
Stock selection weighed on performance in the first half of the year. Ecolab (ECL, Financial) detracted the most from relative performance in the first half as its stock declined 34.5%. The company suffered with higher input costs as most are tied to oil derivatives. Ecolab should report better results as management takes appropriate pricing actions to offset these increased costs. Also, Ecolab is well-positioned to benefit from a rebound in travel as its customers’ businesses improve and its investments in digital technology further differentiate it from its competitors.
Alphabet (GOOG, Financial) was also a significant drag on relative performance, even though it performed well compared to other Technology stocks in the first half of the year. While its revenue grew more than 20% in the first quarter, this was a deceleration from the 30% or more growth it posted in each quarter of 2021. Alphabet continues to have a near-monopoly of online search, and its stock should perform better when investor sentiment swings back toward growth stocks.
Healthcare holdings UnitedHealth Group (UNH, Financial) and Eli Lilly (LLY, Financial) were two of the Fund’s largest contributors to relative performance in the first half. UnitedHealth has executed well on its strategy to shift away from its traditional health insurance model and into healthcare delivery. The company is utilizing its unmatched scale in data analysis to provide the most efficient care possible. Lilly, meanwhile, has benefited from positive study results for its groundbreaking product aimed at reducing Alzheimer’s disease progression and a new weight loss product within its diabetes franchise. We have trimmed positions in both companies to redeploy proceeds into promising stocks hit hard in 2022.
In the second quarter, the Fund started two new positions. Both are Industrial companies that are leaders in markets with growth tailwinds.
Georgia-based Chart Industries (GTLS, Financial), which has a significant manufacturing facility in New Prague, Minnesota, manufactures storage tanks and heat exchangers for the industrial gas and energy markets. It foresees increased demand over the next several years in the LNG (liquid natural gas) industry as countries scramble to adjust to supply disruptions resulting from Russia’s invasion of Ukraine. Also, Chart is positioned to benefit if hydrogen becomes an energy storage solution for utilities shifting to renewable sources.
The Fund’s other new holding is Wisconsin-based Generac (GNRC, Financial), which dominates the market for residential standby generation. Increasingly frequent and severe weather events are driving demand for its products, particularly as consumers rely more on digital connectivity. We saw an opportunity given the significant pullback in the stock over the last year.
Looking ahead, we believe the Fund should perform well even if the current inflationary environment persists. A significant part of our analysis involves looking closely at companies’ competitive positions and their ability to pass on price increases to their customers. We also expect the Fund’s significant exposure to Industrials to benefit as global supply chain disruptions improve.
Andrew R. Adams, CFA Lead Manager
Pete J. Johnson, CFA Co-Manager
Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be lower or higher than the performance quoted. For the most recent month-end performance figures, please call Shareholder Services at (800) 304-7404. Expense Ratio 0.61%.
All holdings in the portfolio are subject to change without notice and may or may not represent current or future portfolio composition. The mention of specific securities is not intended as a recommendation or an offer of a particular security, nor is it intended to be a solicitation for the purchase or sale of any security.
Equity investments are subject to market fluctuations and the Fund’s share price can fall because of weakness in the broad market, a particular industry or specific holdings. Investments in small and mid-cap companies generally are more volatile. International investing risks include among others political, social or economic instability, difficulty in predicting international trade patterns, taxation, and foreign trading practices and greater fluctuations in price than U.S. corporations.
This commentary includes forward-looking statements such as economic predictions and portfolio manager opinions. The statements are subject to change at any time based on market and other conditions. No predictions, forecasts, outlooks, expectations or beliefs are guaranteed.
Foreside Fund Services, LLC. is the Distributor for Mairs & Power Funds.
