CIO upgrades communication services, industrials, and utilities. (UBS)

The combination of still-high inflation, a very inverted yield curve, and tightening bank lending standards (which will likely only get worse due to the turmoil in the banking sector) suggests increased risks of difficult economic conditions later this year.

CIO six-month tactical view
This month, we become more defensive in our sector positioning based on indications that the economy is facing challenges ahead. The yield curve is heavily inverted (although less so over the last week), banks are tightening lending standards (and will likely only get incrementally tighter due to the recent turmoil in the banking sector), and inflation remains too high. Taken together, these are conditions that suggest investors should expect continued headwinds that will cap equity market upside and present downside risks in the months ahead. But the headwinds may not exert more sustained downward pressure on corporate profits and equity markets until later this year, and quite possibly late in the year, especially considering that consumers are still sitting on about USD 1 trillion of excess savings accumulated during the pandemic.

We upgrade communication services, industrials, and utilities. We downgrade consumer discretionary, energy, and real estate. Our most preferred sectors are now consumer staples, industrials, and utilities. Our least preferred sectors are consumer discretionary, financials, and information technology.

Most preferred
Consumer staples: We think earnings for this defensive sector should hold up better than the market as economic growth slows. In addition, we expect further declines in the ISM Manufacturing index, which typically drives outperformance for this sector. Relative valuations are back near historical averages which makes them attractive, in our view, given the sector's defensive growth profile in a potentially challenging macro environment.

Industrials (upgrade from neutral): The sector's exposure to a few secular growth drivers is attractive, in our view. Defense companies should benefit from higher defense budgets in the years ahead, although we acknowledge near-term uncertainty about defense spending heading into the debt ceiling negotiations. In addition, the infrastructure law should support nonresidential construction, while aerospace manufacturers should benefit from large backlogs, even if air travel begins to cool off. Investments in energy supply (fossil and renewable) and reshoring/onshoring trends should provide further support for the sector. Finally, segments of the sector offer some cyclical exposure relative to our two other most preferred sectors, which are more defensive.

Utilities (upgrade from neutral): Similar to consumer staples, this defensive sector should offer ballast in a portfolio, especially given some of the headwinds that we see ahead and arguably cheap valuations for a late-cycle environment. Our fixed income team's outlook for lower long-term interest rates over the balance of the year should make the sector's high dividend yield more appealing.

Communication services (upgrade from least preferred): Competition in digital advertising, video streaming, and broadband continues to intensify. New threats are emerging with the integration of artificial intelligence
(AI) into internet search queries that will usher in a heavier investment cycle for mega-cap incumbents and pressure margins. At the same time, digital ad spending could be at risk if the US economy slips into recession later this year. However, in the near term, economic uncertainty may continue to drive investors to seek safety in high-quality mega-cap growth companies for protection. The defensive nature of telecom companies (around 15–20% of the sector) provides incremental support in an uncertain environment. Investors should be aware that the market-cap-weighted version of the sector is highly concentrated, with Alphabet and Meta accounting for roughly 60% of the total.

Energy (downgrade from most preferred): Valuations aren't demanding, but in the near term, oil markets are better supplied than we anticipated. Risks of an economic slowdown later this year may limit oil price appreciation over the next several months. Long term, we still think the outlook for the sector appears constructive given structurally tight oil markets due to substantial underinvestment in oil exploration and production since 2014.

Healthcare: The relative valuation gap with the broader market is near historical averages, making the risk-reward more balanced. Drugmakers are facing patent expiration on several large products, but promising new drug therapies in large, untapped end-markets—such as Alzheimer's and obesity—might provide some cushion. Labor shortages are easing, aiding a recovery in utilization and medical procedure volumes. Still, policy uncertainty remains a bit elevated pending the implementation of drug-pricing provisions in the Inflation Reduction Act, as well as in managed care on 2024 Medicare Advantage payment rates and potential clawback of overpayments after the government’s recent audit of the industry.

Materials: A potential peak in the US dollar and the reopening of the Chinese economy are positives for the sector. However, the lagged effects of central bank tightening in the US and Europe could weigh on end-demand.

Real estate (downgrade from most preferred): Turmoil in the banking system has made financing more difficult. Companies in the sector are generally more highly indebted and rely on easy access to capital, which could be more challenging. The sector is cheap and offers a good mix of secular and cyclical exposure. But uncertainties around access to capital may linger and lead to higher costs that could prevent the sector from outperforming.

Least preferred
Consumer discretionary (downgrade from neutral): The sector has been a strong performer this year despite continued questions about consumer demand for goods and high sector valuations. Elevated mortgage rates and poor homebuyer affordability are headwinds for the housing-related segments of the sector. The sector would be particularly vulnerable if hard-landing fears become more prevalent. Investors should be aware that the market-cap-weighted version of the sector is highly concentrated, with Amazon and Tesla accounting for roughly 40% of the total.

Financials: It is possible that as the banking stress eases, the sector could experience a rebound. But fundamental headwinds will still be present such as rising funding costs as banks compete for deposits, slower loan growth if there is a broader slowdown, and increased regulatory scrutiny that could mean less return of capital to shareholders. Recession risks remain elevated, and credit costs could rise substantially if the unemployment rate climbs.

Information technology: The sector has seen a spike in its relative valuation following the recent turmoil in the banking system. Our outlook for a decline in S&P 500 profits in the quarters ahead will likely be a fundamental headwind for the sector. Enterprise tech spending tends to be correlated with overall corporate profits. Finally, semiconductor demand is also slowing in some segments, and this industry tends to be correlated with the ISM Manufacturing index, which will likely continue to be under pressure.

Read the full report US equity sectors 23 March 2023.

Main contributors: David Lefkowitz, Nadia Lovell, and Matthew Tormey

This content is a product of the UBS Chief Investment Office.

For more on these equity positioning changes, listen to the podcast Top of the Morning: The week in review and preview