CIO favors quality stocks, which they view as an anchor given these stocks typically outperform across much of the economic cycle. (UBS)

The equity market has started off the year with a bang —with the S&P 500 up 4% year-to-date, reaching all-time highs for the first time in two years and breaking through the psychological level of 5,000. Better-than-expected economic growth data helped to fuel the rally and increase investors’ confidence in a soft landing. But despite strong economic momentum, the cyclical areas of the market continue to lag, and breadth remains narrow with mega-cap technology stock performance leadership persisting. By comparison, the equal-weight S&P 500 index is roughly flat for the year. Interest-rate sensitive sectors have been hindered by the backup in bond yields, with the yield on the 10-year Treasury up 40bps since the start of the year as the market repriced expectations for Fed rate cuts. At its peak in early January, the futures market was pricing in over 170 basis points of easing for this year, starting in March. Hot data, including CPI, has since pushed that down and out to 95 basis points, or 3-4 cuts, starting in June—which is more in line with our expectations.

While the start to the Fed easing cycle could be delayed, the good news is it's largely on the account of strong growth data—which is still positive for stocks and corporate profits. We’re in the tail end of the Q4 reporting season, with just the major consumer retailers set to report in coming weeks. With 80% of the S&P 500 market cap having reported, results are stronger than our initial expectations. Earnings are on track to grow more than 7.5% and outlooks have been sanguine with companies confirming some of trends suggested by the macro data. The consumer remains resilient, manufacturing is showing signs of bottoming, green shoots are emerging in capital markets, and input costs are normalizing from previously elevated levels. The tone increased our confidence in our high-single-digit earnings growth outlook for this year, with the potential for upside.

Our year-end 2024 S&P 500 price target is 5,000 in our base case. However, our upside goldilocks scenario calls for 5,300. We aren’t calling for goldilocks at this stage as the recently hot inflation data could keep the Fed on hold and rates higher for longer. But admittedly, the fundamental growth data has been tracking better than our base case. That said, valuation multiples have expanded further and are elevated at 20x on a forward P/E basis, despite the uptick in bond yields. This is likely to restrain market price appreciation from here and performance is likely to be more earnings driven.

We remain constructive on equities, but performance is likely to be more modest from here. That said, we expect market performance to broaden out as the year progresses. Therefore, having a balanced exposure to various sectors and themes is fitting in such an environment. We favor quality stocks, which we view as an anchor given they typically outperform across much of the economic cycle. Within our tactical equity themes, "Time for quality" and "Pricing power standouts" offer this exposure. We would continue to take advantage of laggards ("Investing in selfhelp”), as well as segments of the market where weak demand has bottomed and earnings are inflecting higher ("Select semis"). We also see select opportunities in secular growth trends, including artificial intelligence, reshoring, infrastructure, energy transition, and healthcare innovation —which can be accessed through our “Made in America” and “Diabetes and obesity” themes. Our newly launched "Housing recovery" theme should benefit from a decline interest rates and favorable demographics trends.

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

1. Housing recovery—Housing demand remains strong due to favorable demographics trends, with the largest generation in US history—millennials—moving into prime homebuying age. However, home inventory has been hovering at historically low levels as the majority of current homeowners are locked into mortgage rates that are well below prevailing rates and are reluctant to give that up. But, as the Fed is likely to ease monetary policy this year, we expect mortgage rates to fall, which should improve affordability and unlock existing home supply. We focus on companies that could benefit from a potential re-acceleration in housing activity.

2. Select semis—We believe a bruising downturn in the key end markets (PCs, servers, and smartphones) is near an end, setting up a better backdrop for select semiconductor suppliers. We focus on companies that we believe will benefit from the recovery in key end markets and where consensus earnings estimates, which have moved off the lows, still do not capture the potential upside of improved end markets and restocking.

3. Diabetes and obesity—Diabetes and obesity are prevalent diseases with high unmet needs, but recent treatment innovations appear promising. 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.

4. Investing in self-help—In a slowing 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.

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

6. 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.

7. 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.