There will be incremental headwinds into year-end, with the resumption of student debt payments and potential lag effects of higher interest rates, but CIO still expects growth, albeit at a slower pace. (UBS)

For much of this year, the equity market has shrugged off the move higher in bond yields, but that trend reversed in the last several weeks. The Federal Reserve’s hawkish and firmer “higher for longer” stance, stronger economic growth outlook, and concerns about increasing Treasury supply to fund the fiscal deficit have helped to drive yields higher. Over the last month, the yield on the 10-year Treasury jumped over 50 basis points and briefly touched 4.88%—its highest level since 2007. This caused a recalibration of elevated equity valuations and pushed the S&P 500 down about 8% from its late-July 16-month high. As investors continue to digest higher bond yields, markets could remain choppy. That said, we believe the risk reward has improved, with the S&P 500’s forward P/E now at 17.5x—down from 19.5x earlier this year—and corporate earnings likely to inflect higher from here.


The economy seems to be on a path to a soft landing, with a resilient consumer and easing inflationary pressures, particularly in goods. Real GDP growth for Q3 is pacing above trend, at over 3%, driven by strong consumption, and could be the strongest quarter so far this year. There will be incremental headwinds into year-end, with the resumption of student debt payments and potential lag effects of higher interest rates, but we still expect growth, albeit at a slower pace. The consumer remains healthy and has more excess savings than previously thought. Though there are signs of softening, the labor market is still robust with a relatively low unemployment rate at 3.8% and still meaningful excess demand for workers—the ratio of the job openings to unemployed is at 1.5. This should help support spending.


With equity volatility picking up, we think investors need to be selective in their allocations. As a result, our tactical equity themes tilt in favor of quality (“Pricing power standouts” and “Time for quality”). We would take advantage of recent laggards (“Investing in self-help”). We also see select opportunities in secular growth trends, including artificial intelligence, reshoring, infrastructure, energy transition, and healthcare innovation—which can be accessed though our “Made in America” and “Diabetes and obesity” themes.


More details about all these tactical themes can be found below.


1. Diabetes and obesity—Diabetes and obesity are prevalent diseases with high unmet needs, but recent treatment innovations appear promising. We believe the pullback in diabetes-related stocks offers a tactical entry point to what we see as an attractive secular growth story. We focus on the market leaders across treatment categories, where we believe there is upside to profit estimates driven by new product cycles and increased penetration in growing addressable markets.


2. 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 that have clear and measurable initiatives—with emphasis on restructuring and product portfolio and capital use optimization—and are likely to increase margins and cash flows regardless of an uncertain macro backdrop.


3. 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.


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.


5. 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


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