Last week's softer than expected inflation reading has prompted a dramatic shift in financial markets. Expectations for Fed tightening have eased slightly and the yield on the 10-year Treasury has fallen by almost a quarter of one percent. Stocks also responded very favorably with the S&P 500 now up 6.5% in just the last two days. Moves within the equity market have been even more dramatic with a sharp rally in growth stocks and explosive gains in some of the worst performers this year.
It’s possible this rally extends a bit further as investors reposition portfolios for a downshift in inflation. Still, we think there are a few things to consider when gauging the outlook. First, valuations may become a bit more of a headwind. The S&P 500 P/E is now more than 17x bottom-up consensus EPS estimates, compared to the pre-pandemic average of 16.6x. While 18x is possible, we think that would be near the upper limit of what is achievable as corporate profit growth continues to slow. That’s only 4% higher than current levels.
Second, while it is good news that inflation is beginning to fall, it’s still not clear how low inflation will go. We think it will be hard for the Fed to get inflation back to its target of 2% with the unemployment rate near the lows of the last 65 years. This tight labor market is driving rapid wage growth, prompting many companies to raise prices. In other words, we think recession risks will remain elevated until there is much more visible cooling in the labor market. That could happen without a recession, but it will take time for this to become evident. And if the US economy does slip into a recession, stocks could fall 15-20% from current levels.
Third, corporate profit growth continues to slow. The tightening of financial conditions is restraining access to capital. This is now becoming more evident in a host of measures including the Fed’s most recent Senior Loan Officer Opinion survey, which suggests a decline in corporate profit growth in 2023 that could be even larger than our estimate of a 4% contraction. And on our lower than consensus earnings numbers, the S&P 500 is already trading at a P/E of 18.6x.
So overall, we think it makes sense to continue to be somewhat cautious in portfolios. We continue to believe our tactical equity themes are appropriately positioned given the still-material headwinds. We stay focused on high quality companies and pockets of the market that are exposed to more durable growth drivers—whether it be companies that have pricing power, or have leverage to infrastructure spending, energy efficiency, or security priorities.
More details on all of our themes can be found below and in the following pages.
1. 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.
2. Security takes center stage—Russia's war in Ukraine will likely have 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.
3. 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.
4. Pricing power standouts—Elevated input costs are creating 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.
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Main contributors: David Lefkowitz, Nadia Lovell, Michelle Laliberte, and Matthew Tormey
This content is a product of the UBS Chief Investment Office.
