Despite notable developments, the US equity market, as measured by the S&P 500, is roughly flat over the last month and has traded in a narrow range of 3%. Concerns over continued regional banking stress, the looming debt ceiling X-date, and uncertainty about the scope of slowdown in inflation have been offset by a good first-quarter earnings season, still-robust labor market, and an imminent end to the Federal Reserve tightening cycle. However, market breadth has been weak, with just a few stocks, primarily in the technology sector, continuing to account for the bulk of year-to-date gains. Late-cycle dynamics persist, with 1Q23
GDP slowing to 1.1% and leading indicators pointing to a further slowdown ahead. The ISM manufacturing index (a measure of business activity) has been in contraction territory for the last six months, while tighter credit lending conditions and weaker loan demand are at recessionary levels.
Yields across much of the Treasury curve continue to edge lower, lending some support to equity market valuations. The 2-year Treasury yield now sits at 4% and the 10-year Treasury yield at 3.5%, about 100 and 50 basis points lower, respectively, than before the start of the regional banking turmoil in March. Worries about potentially stricter lending standards have led the federal funds futures market to price in about 70bps of rate cuts in 2H23—which seems aggressive and unlikely, in our view. While core inflation has moderated to 5.5% year-over-year (down from the 6.6% cycle high in September), it remains sticky—particularly in services—and well above the Fed’s 2% target. Therefore, we believe rates are likely to stay higher for longer and could be a headwind to equity valuations, which appear extended. The S&P 500 forward P/E of 18x is above long-term averages and historically has only been achieved when expected earnings growth is much higher than it is currently.
We continue to believe that the risk-reward for equities is unattractive, with the risk skewed to the downside in the second half of the year. Consumer sentiment is bleak, and credit-card data suggests spending is weakening, even among higher-income consumers. The NFIB small business optimism index is at the lowest level in a decade. The debt ceiling standoff is an overhang and could be a source of near-term volatility as the early June X-date— when the Treasury is at risk of running out of funds—draws closer.
We continue to recommend investors focus on segments of the market where earnings growth is more durable and valuations are reasonable. 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 investors with a bit more risk tolerance, 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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