From a tactical theme standpoint, CIO remains 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. (UBS)

Rally broadening, laggards take the lead The US second quarter earnings season is underway, and the focus will likely shift from the macro to the micro. The market has staged an impressive rally over the last couple of months—up over 9% since the end of May, reaching a 16-month high and now roughly 5% off its January
2022 all-time high. Much of the recent rally has been driven by macro factors, including stronger-than-expected economic growth, evidence of disinflation and continued artificial intelligence (AI) enthusiasm. Valuation multiples have expanded further, despite higher real bond yields, with the forward price-to-earnings at 19.5x—well above longer term averages. We think the baton now passes to the corporate earnings growth outlook, and the reporting season could be a litmus test on whether fundamentals can catch up with the price momentum. Positioning and investor sentiment have significantly improved and are no longer meaningful tailwinds. While companies are likely to beat the low consensus earnings bar (-9.5% YoY S&P 500 EPS), price action might be more muted. With a good deal of optimism already priced into the market, we believe upside from here is limited.


We expect a more range bound market, with some choppiness under the surface. In this environment, we continue to advise seeking opportunities in year-to-date laggards, where valuations are more reasonable.
Performance leadership has been concentrated year-to-date—market-weighted S&P 500 index +19% versus equal-weighted index +9%. However, in the last month, breadth has improved with the rally broadening out to some cyclical sectors. In fact, the equal-weighted index has outperformed since June, and we expect that to continue.


From a tactical theme standpoint, we remain 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. We launch a new theme, Investing in self-help, focused on companies with measurable self-improvement initiatives that could drive profitability regardless of the macro backdrop.


More details about all these tactical themes can be found below and in the pages that follow.


1. Investing in self-help—In a more challenging economic growth environment, we believe companies with self-help measures to enhance profitability are likely to be better-positioned and rewarded by investors. We identify companies, with clear and measurable initiatives—with emphasis on restructuring and product portfolio and capital use optimization—that are likely to increase margins and cash flows regardless of an uncertain macro backdrop.


2. Made in America—Over the last two years, the US Congress has passed three acts aiming to upgrade US infrastructure and boost domestic manufacturing of critical resources. Together, these pieces of legislation set the nation up to embark on one of the most significant government investment spending plans we have seen in years.


3. 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.


4. 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.


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


Reach out to your financial advisor for a copy of the full report “Tactical US Equity Themes: Monthly update,” a one-stop resource to access CIO's highest conviction thematic equity ideas.