US stocks are off to a good start this year, propelled by better economic growth prospects in Europe (natural gas prices are lower largely due to a mild winter) and a rapid improvement in the outlook for China on the heels of the country's abandonment of its zero-COVID policy. Closer to home, the risk of even higher Fed rate hikes has diminished due to a slowdown in wage pressures and more benign inflation readings. Generally cautious investor positioning has also helped propel gains as some market participants may have been caught offside by the improving growth and inflation mix.
Still, we have a hard time seeing much near-term equity market upside from current levels. Based on tightening bank lending standards, a likely move higher in the unemployment rate (in order to reach the Fed's 2% inflation target), and continued weak business sentiment, we believe S&P 500 profits will be under pressure in the coming months. Additionally, valuation multiples do not leave that much room for upside. Since the early 1980s, the only time the forward P/E has been higher than 18x was during periods when profit growth was very rapid (10-20% growth) or interest rates were at rock-bottom levels similar to 2020-21 when the 10-year Treasury yield averaged around 1%. Furthermore, while the Fed may be getting closer to the end of its rate hikes, it will likely keep rates at a lofty level until there are clear signs that inflation is moving back to its 2% target, which may take some time.
Overall, we think stocks will have a hard time making a further sustainable move higher until investors have some confidence that corporate profit growth will re-accelerate. But there are still risks that the economy slips into a full-blown recession, especially because the market seems to think the Fed will shift to interest rate cuts towards the end of the year. But history suggests that the Fed doesn't cut rates unless the unemployment rate is higher or inflation is lower than where it will likely be later this year. We think our open themes continue to present an opportunity in the current market environment, and we make a few changes to the stock lists. More details about the individual themes and changes to the related stock lists can be found below and in the following pages.
1. Reopening China—After years of enforcing a strict COVID-19 containment policy, China is rapidly exiting its zero-COVID measures putting it on track for a full reopening in Q1 2023. 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. Security takes center stage—Russia's war in Ukraine is having a meaningful and long-term impact on security considerations that will affect conventional defense spending, cyberspace, as well as energy, food, and semiconductor supplies. We identify companies that are leveraged to these trends.
4. Resilient spending—Businesses that are leveraged to infrastructure spending, renewables, 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.
5. Pricing power standouts—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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