The near-term environment remains mixed, and US stocks could continue to trade in their range, says CIO. (UBS)

The US equity market continues to grind higher and is now at the higher end of its nearly one-year range. The turmoil in the banking industry that led to deposit outflows and a few regional bank failures in March has subsided, helping to tame contagion fears. Macroeconomic data has since surprised to the upside and the economy is on track for 2.5% growth for 1Q23, per Atlanta Fed’s GDPNow forecast. The strength of the labor market and signs of inflation cooling have boosted soft landing optimism in recent weeks. But market breadth remains poor, with just 30% of S&P 500 companies outperforming the index year-to-date.

Falling bond yields have also aided a re-rating in equities. The yield on the 2-year Treasury dropped to 4.2%—down from its 16-year high of 5.1% in early March—while the 10-year has fallen to roughly 3.6%. Rate cuts in 2H23 are now being priced in by the Fed funds futures market. On the back of this, equity valuations pushed higher, with the forward P/E now over 18x—above longer term averages. However, we remain cautious as this valuation level is historically associated with accelerating double-digit earnings growth, which is unlikely to occur over the next year. Forward indicators point to lower economic activity and corporate profits ahead. The ISM manufacturing index (a measurement of business activity) has been on a downward trend and in contraction territory for the last five months. As seen in the Fed’s Senior Loan Officers’ Opinion Survey (SLOOS), lending standards were tightening and loan demand softening even prior to the banking turmoil, and conditions are likely to deteriorate further as banks hoard more liquidity.

The near-term environment remains mixed, and US stocks could continue to trade in their range. The ongoing 1Q23 earnings season could provide some support as companies are likely to beat the lowered profit bar, after significant cuts to consensus estimates over the last three months. That said, we continue to believe that 2H23 will be more challenging as the economy feels the drag of tighter monetary policy and lending conditions. 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. More details about all these tactical themes can be found below and in the pages that follow.

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