Market stress and volatility continued through the third quarter of 2022, as supply chain frictions, inflation, geopolitical tensions, and rising interest rates added to economic headwinds and reined in investor sentiment.
The Federal Reserve (The Fed) continues to aggressively raise interest rates to slow the economy and reduce inflation. The recent consensus among the Fed governors is that the Federal Funds rate will likely rise to 4.625% in 2023, with the intention of keeping rates higher for longer to get inflation under control.
The normalization process currently underway likely won’t be smooth. We continue to watch mortgage rates, which rose roughly 1.0% during the third quarter. Nearly half of this increase was during the last week of September. As of September 30, the average rate for a 30-year fixed mortgage was 7.06%, which compares to 3.01% one year ago, and an average rate of 7.76% during the previous 50 years. The Fed’s inflation fighting tool of raising interest rates is a blunt instrument, and a powerful one, and it will likely slow the rate of borrowing by businesses and consumers. Housing and all the things associated with owning a home are a meaningful portion of the economy, and the slowing housing environment will likely slow the economy overall.
Still, while GDP has turned negative, other economic indicators remain upbeat. While ISM indicators have slowed, they remain at levels still signaling modest economic growth.
Household spending rose 0.4% in August after a 0.2% drop in July. While consumer confidence data fell earlier in the year, a drop in oil prices helped sentiment rise in August to its highest level since May. After reaching $5 per gallon in mid-June, the average price of regular gasoline was about $3.80 a gallon nationwide in September. The labor market also remains generally tight: The August unemployment rate stayed low at 3.7%, and job growth continued at a steady pace, though there was a decrease in job openings in September. Even with the economy softening, the initial claims for unemployment stayed low, implying that companies are shying away from letting employees go. In fact, the unemployment rate is less likely to move much higher due to the current labor shortages.
Despite a mix of positive and negative indicators, the market continues to express profound nervousness about the economy’s current and near-term prospects. In the first three quarters of 2022, the S&P 500 Total Return (TR) declined 23.87%. A rally from the June 13 lows has reversed, and those lows are being retested as investors prepare for third quarter earnings reports. In the third quarter, the S&P 500 TR declined 4.88%, the Dow Jones Industrial Average TR fell 6.17%, and the Bloomberg U.S. Government/ Credit Bond Index dropped 4.56%.
Future Outlook
We believe that we’re entering a transition from a period of abnormally low interest rates to something like “the old normal,” when the Federal Funds rate was commonly between 3-4 percent. While this transition has caused the market to sell off this year, the long-term prospects for investors and for the economy in general remain positive. The market, the economy, and corporate profits can grow nicely even with the Fed Funds Rate between 3-4 percent. Rates were generally that “high” during the 1990s and the first decade of this century, which was also a period of generally positive economic performance. Readjusting to that old normal has caused much of this year’s market volatility, since the market’s valuation reflected the low interest rates of the past decade.
It’s also worth noting that corporate earnings haven’t fallen. While the rate of earnings growth has come down, the current consensus for earnings growth is still 7.4% for this year and 7.7% in 2023.
Already, supply chains are beginning to heal, shipping costs have fallen from peak levels, and certain components of production are becoming more available, though labor costs remain elevated. Ironically, just as companies are beginning to deliver on high purchase order backlogs, demand is beginning to ebb, in part due to rising interest rates. This combination of rebounding supply and ebbing demand is not surprising. It typically marks the completion of an inventory cycle, and it is often followed by falling prices.
This normalization process could result in volatile earnings reports in the near term, and it could even result in a brief recession. But in the longer term, we believe it should prove to be a positive for business. With lower inflation and the end of interest rate hikes, businesses will likely regain confidence in the economic outlook. With confidence comes investments in capital and labor, and a new expansion cycle begins.
In short, the Fed’s actions and the rebalancing of supply chains and inventories are working to slow the economy and tamp down inflation. This is a process that will take time. But keeping the entire business cycle in focus provides perspective for appreciating that while the process is uneven, disruptive, and even painful, it is normal, and has happened many times before.
Performance Review
The Mairs & Power Growth Fund slightly outperformed its index, the S&P 500 Total Return, in the third quarter. The Fund was down 4.61% while the index was down 4.88%. Year-to-date the Fund is still lagging the index as the Fund has declined 25.29% compared to the index, which is down 23.87%. The Fund is also slightly underperforming year-to-date relative to peers, as measured by the Morningstar US Fund Large Blend category, with the category down 23.31%.
Sector selection played a minimal role in year-to-date relative performance with a significant headwind from not owning stocks in the top performing sector, Energy, mostly offset by being overweight in the outperforming Healthcare and Industrial sectors and underweight in the underperforming Technology and Consumer Discretionary sectors.
Stock selection was the primary driver of year-to-date relative underperformance as several of our higher “growth” holdings have pulled back this year. Our investment strategy focuses on investing in companies with sustainable durable competitive advantages. We favor companies that are gaining, and have the capability to continue to gain, market share within their respective industries. Therefore, their growth rates tend to be better than their peers and the market overall.
That doesn’t mean we will buy a growth stock at any price. We are disciplined about valuation at Mairs & Power, and it remains a major component to our investment strategy.
In an inflationary environment like today, future earnings become less valuable. A dollar today is worth more than a dollar in a year. So, growth companies that tend to pay lower or no dividends become less valuable, while companies that tend to have higher dividend payments, become more valuable. Our focus on holdings with durable competitive advantages has led to steady long-term performance and we believe this strategy will continue to benefit the Fund over the long term. But it has negatively impacted relative performance in the current environment.
Alphabet (GOOG, Financial) is a good example of a growth company that has fallen out of favor over the last nine months. Alphabet is one of the Fund’s largest holdings and has been a great holding over the past few years. Its durable competitive advantage has allowed it to take market share in the current downturn and its long-term prospects continue to improve, yet the stock is down more than 33% this year. Our expectation is that the Federal Reserve’s fiscal and monetary policy around interest rates will bring inflation back to more normal levels over time and the preference for, and underperformance of, “growth” investments will reverse. Lower inflation will make growth stocks more attractive investments and likely raise their valuation levels, resulting in outperformance relative to “value” investments.
Besides Alphabet, Ecolab (ECL, Financial) and Bio-Techne (TECH, Financial) were other notable laggards this year. Ecolab was hindered by input cost inflation earlier this year, specifically higher energy prices. It has taken the company some time to pass through higher prices, but since it has started the process, the stock is now performing better. Finally, Bio-Techne, another Twin Cities company, has lagged the market primarily as the result of its status as a growth company. Management has executed extremely well in transforming the company from nearly a no-growth business a decade ago to a company that is now posting organic growth regularly in the double digits. In our view, both companies have sustainable competitive positions that will allow them to pass on inflation pressures and allow them to outgrow their peers as this inflationary cycle plays out.
Offsetting these detractors were Digi International (DGII, Financial), Eli Lilly (LLY, Financial), and UnitedHealth Group (UNH, Financial), all positive contributors to performance this year. Digi, a small cap Twin Cities company, has reinvented itself under its new management team. The stock has done well this year as management’s focus on Internet of Things connectivity has paid off in an environment of increased digital connectivity driven by significant interest in data analytics. Eli Lilly has benefited from an extremely successful research and development effort, with positive data from clinical trials on new groundbreaking therapies in weight loss and Alzheimer’s disease. Finally, UnitedHealth, the Twin Cities largest public company, has been successful in its rollout of OptumHealth, its new health service business.
While our investment strategy has been somewhat out of favor this year, this has allowed us to take advantage of mispricing opportunities in companies with durable competitive advantages and above average growth prospects. Over the long term we expect this strategy will benefit shareholders.
A couple final notes: We expect to report a 2022 capital gains estimate in mid-November, so please
check our website then for the estimate. Lastly, after roughly 80 years in the First National Bank building, Mairs & Power will be moving in mid-December to a new office at Wells Fargo Place, still in downtown St. Paul. We remain committed to our hometown, where we were founded 91 years ago, and our new location will help us adapt to a changing work environment. The office layout provides more opportunities for collaboration and enhances how we serve our clients.
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.
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