Yes. Aggressive central bank tightening has caused economic growth to slow in Europe and the United States, and we expect that the recent banking sector stress will further weaken economic growth. Now is the time for investors to tactically overweight quality equities, given this style has tended to outperform broad equities during periods of economic contraction.
Banks have been tightening lending standards for several quarters due to an expected deterioration of credit quality across various loan types. This headwind to growth has become more pronounced since the collapses of Silicon Valley Bank and Signature Bank and the emergency rescue of Credit Suisse. Banks are now likely to tighten lending standards even more, restricting the flow of credit among households and businesses and ultimately sapping economic growth. Restrictive credit conditions can also impact corporate profitability, suggesting earnings growth may fall further in the quarters ahead.
An environment of slower economic growth and credit contraction would be more challenging for more leveraged cyclical companies that lack reliable earnings streams. Quality stocks can offer more ballast in such environments due to their more defensive equity characteristics. While definitions vary, quality stocks tend to have high returns on equity, low financial leverage, and stable earnings growth. Companies that meet these criteria are typically mature with wide economic moats and tend to benefit from a flight to safety during economic downturns.
Indeed, in each of the past six recessions, the MSCI World Quality Index outperformed its broad market counterpart by an average of 5 percentage points. This quality outperformance not only applies to economic downturns, but also to broader stock market downturns; since 1999, the MSCI World Quality Index has bested the MSCI World Index by an average of 50 basis points during months of negative equity returns.
Investing in quality stocks is not always a free lunch. Quality stocks are not cheap today in absolute terms, but appear reasonably priced relative to the broader market, which is also trading at a premium. Based on our normalized price-to–cash earnings metric, quality trades at 1.35x the broader equity market, a premium in line with its historical average. Given the considerable economic uncertainty right now, this seems a reasonable price to pay.
Sector concentration is another consideration. Today, the MSCI World Quality Index has a 36% weight to information technology (IT) stocks and sizable allocations to tech-like sectors, such as communications services. While these sector allocations could prove defensive in a recession, they could also represent a concentration risk when the economic momentum shifts. As a historical analogy, the MSCI World Quality Index trounced the broader equity market during the tech bubble in the late 1990s, when its exposure to the IT sector more than doubled. During the recession that followed in 2001, quality still held up better than broader equities. However, relative performance stumbled in the subsequent economic expansion from 2001 to 2007 as cyclical sectors rallied.
Finally, investors should be mindful of practical considerations when seeking more quality exposure. Tactically overweighting quality in a portfolio of active managers is seldom a straightforward exercise. Managers that style themselves as quality-focused can look very different from one another, given structural biases in individual investing processes. For investors that have quality exposure, it may be prudent to adjust relative sizing of existing manager positions rather than hiring a new manager.
Sean Duffin
Senior Investment Director, Capital Markets Research