After a strong rally at the start of the year, US stocks have been whipsawed in recent weeks due to turmoil in the banking industry. In a matter of weeks, three regional US banks failed, after coming under immense pressure from heavy deposit outflows. The quick and decisive actions by regulators—including implicitly guaranteeing all uninsured deposits and making additional funding available to banks—helped to stem contagion concerns. As a result, within financial markets there has been a flight-to-quality and heightened fears of a hard landing—sending bond yields lower and high-quality and defensive stocks higher.
The turbulence in financial markets has created incremental challenges for central banks, as they try to balance financial instability risk with the need for additional rate hikes to combat still-high inflation. The bond market has quickly repriced and now assumes a peak fed fund rate of 4.9% versus 5.7% previously. The yield on the 2-year Treasury has tumbled to 4% from 5% in early March, and while it’s still higher than that on the 10-year Treasury (i.e. an inverted curve), the gap between the two has narrowed.
Historically, this steepening of the curve has been associated with a recession in the coming quarters. That said, recent macro data—including a strong labor market—suggests the economy remains on relatively solid footing. In fact, the Atlanta Fed’s GDPNOW forecasts 3.2% GDP growth for 1Q23. However, as the year progresses, a potential tightening of credit lending standards and liquidity in the banking system could pull forward the period of sub-trend economic growth.
In this environment, we believe that US stocks will remain volatile, with risks to the downside. Valuations are fairly full and earnings estimates are likely to be reduced further as the economy feels the drag of tighter monetary policy.
We recommend investors focus on segments of the market where earnings growth is more resilient. In this context, our tactical themes are focused on high quality companies, those that have pricing power, or are leveraged to long-term growth drivers that are more insulated from economic growth. For those investors that are looking to take a bit more risk, we have a list of stocks that are leveraged to China’s reopening.
1. Reopening China—After years of enforcing a strict COVID-19 containment policy, China rapidly exited its
zero-COVID measures and the economic recovery is now underway. Top policymakers have shifted the focus to economic growth and are likely to continue to adopt pro-growth initiatives to smooth the path. We identify US companies that we expect to benefit.
2. Time for quality—High quality stocks tend to perform well later in the business cycle or when the economy is in recession. With limited or no slack in the economy, it is clear that the business cycle is somewhat mature. This suggests that investors should focus on high-quality companies, which we define as those with a high return on invested capital (ROIC) and stable profit margins.
3. Resilient spending—Businesses that are leveraged to infrastructure, renewables, defense, aerospace aftermarket, energy efficiency, segments of enterprise IT spending, and efforts to expand energy supply should remain relatively well-supported despite a more uncertain macro environment.
4. Pricing power standouts—Still-elevated input costs have created a more challenging backdrop for many businesses. Companies with pricing power should be better able to pass on these costs to consumers and protect profit margins. We identify companies with pricing power as those with historically high and stable gross profit margins and a large market share in their respective industries.
Main contributors: David Lefkowitz, Nadia Lovell, Michelle Laliberte, and Matthew Tormey
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