Thursday, February 14, 2019

Sector Inspector: Our Macro Framework for US Markets and Why We (Still) Like Consumer Discretionary, Financials & Energy

Spencer Joyce, CFA
Author position
Vice President | Markets Analyst

Hilliard Lyons’ Investment Strategy & Research team is dedicated to supporting you and your Wealth Advisor. We provide investment guidance and help you separate meaningful news from idle noise via timely market commentary.

In the Sector Inspector series, ISR presents our view on US equity market sectors. Our goal is to help investors understand US equity markets by focusing on discrete items that impact groups of stocks. We also seek to draw attention to areas where we see opportunity, and to highlight groups we believe are less compelling. It should be noted, ISR believes in diversification and that most investors should be exposed to most (or all) sectors.

Changes This Month: No Changes.

Our Current Macro Framework for US Markets

Many themes and opinions impact our sector views; several are detailed below. We view the overall market at 16.4 forward earnings as modestly attractive on valuation.

  • The protectionist bent to US trade policy is destructive for most US multi-nationals. However, consensus seems to assume a trade deal with China is reached, and potential for tariff escalation with the European Union seems underappreciated.
  • The energy sector endured a volatile Q4, but oil prices seem to have stabilized (prices now effectively flat from ~3 months ago). Meanwhile, much of the sector set Cap Ex plans in recent weeks.
  • We are cognizant of rising cost pressures for companies, and the risk that tariffs bolster the trend. Examples include rising wages and elevated transit costs, and a headwind from a stronger US dollar.
  • A pivot in January suggests that the Federal Reserve may be ‘on hold.’ Consensus is for zero interest rate hikes from the Fed this year. Over the past several weeks, financial conditions have generally loosened, credit spreads have compressed, and rates have trickled lower.
  • We believe the US economy is strong, particularly the US consumer. Our confidence here is predicated on the US worker. Unemployment is low, wages are growing, and our home economy continues to add jobs. Sentiment readings have waned somewhat, but we believe the government shutdown may be obscuring more durable trends. We believe the outlook for US growth is more resilient than most of the rest of the world.

We Like: Consumer Discretionary, Financials & Energy

Consumer Discretionary: We like Consumer Discretionary as a play on the US consumer. We see consumer spending as one of the more dependable facets of the current global economic backdrop due to low unemployment and rising wages. Affordable gas prices factor in here too, as does a reduced tax burden for most spenders. The sector may not appear cheap at 19.7x forward earnings, but we believe this is reasonable given growth expectations.

We do acknowledge some challenges for the sector. Activity in Auto and Housing remains uninspiring, but both industries could benefit from the recent Fed pivot. Pockets of retail are overleveraged and face disruption, and goods manufacturers are likely to grapple with cost inflation. That said, the sector is large, with its share of insulated verticals (e.g., travel & leisure), and there are plenty of companies with resilient operational and financial positions.

Financials: We like valuation in Financials at just 11.6x forward earnings expectations. Aside from the depths of December’s correction, the sector is the cheapest it has been since 2012. Balance sheets are improved from the prior cycle, and earnings are less cyclical. Political scrutiny has shifted to other sectors (e.g., Tech, pharma), which supports returns on equity (ROEs) and capital return (dividends and buybacks). An uptick in M&A could be a catalyst for multiple expansion; two southeastern US-based institutions recently agreed to merge and form the country’s 6th largest bank.

A flat yield curve is not necessarily constructive, but we believe this risk is reflected in stock prices. Furthermore, a less active Fed is likely supportive of the US economy in general, and Financials are an economically sensitive sector.

Energy: Oil prices were collapsing as companies set investment plans for 2019, and analysts are completing an earnings season of ratcheting down expectations. With oil prices potentially stabilizing at levels that are manageable for most companies, we view the qualitative narrative as constructive. More broadly, Energy is one of the least correlated sectors in the market, and we believe there is value for long-term investors that are willing to add the group while it is out of favor. Energy was the worst performing sector on a total return basis in 2018.

At 18.2x forward earnings, Energy’s valuation is a little on the expensive side versus average. But given the items noted above, we believe this embodies very low earnings expectations. Among production companies, we prefer larger enterprises with stronger balance sheets and diverse business interests. Separately, we believe the North American infrastructure space (e.g., pipelines) is more resilient than volatile stock prices might imply.

We Dislike: Consumer Staples

Consumer Staples: Consumer Staples are usually lower-margin businesses, which we believe leaves the sector ill-equipped to handle rising input costs or dislocations in the global supply chain. A small uptick in costs has an outsized impact on profitability for companies with low margins. We view 18.2x forward EPS as too expensive for a low-growth sector primed for disruption, particularly with the broader market not overly expensive.

Brands have historically held pricing power, but we believe this phenomenon is in structural decline. Consumers are increasingly looking for niche/super-premium brands, while at the low end, ‘off brand’ products are growing more competitive. A strong consumer has positive general implications for Staples, but we believe there are better ways to leverage this trend.

The Rest, in Two Lines or Less (ordered by weighting in the S&P 500)

Technology: Valuation is a bit rich for us, particularly as Tech generates more of its sales abroad than any other sector while relying on a global supply chain. We believe the Trump White House represents outsized risk to this sector.

Healthcare: Pressure on prescription drug prices represents a risk that could pressure the sector for much of 2019. Demographic trends are still a tailwind, and Healthcare should be able to defend margins versus cost pressures.

Communication Services: We are drawn to the sector as a de facto way to play the consumer, but in total, still prefer Discretionary. Sector makeup is barbelled, with old Telecom (deep Value) and some leading ‘tech’ growth companies.

Industrials: Seemingly the most sensitive sector to day-to-day developments in Trade, and we hesitate to make a bold call here in either direction. The sector in aggregate is exposed to rising cost pressures and global growth projections.

Utilities: Valuation is too expensive, with the sector at its highest forward P/E since late 2017. Utilities still represent an opportunity to be contrarian (which we like), but we believe there will be better times to focus on the group.

Real Estate: A more dovish Fed is important, but stocks have already rallied. We like the US-centric exposure. We believe industry selection remains highly important (e.g., malls vs. single-family housing vs. data centers, etc.).

Materials: The turn lower in interest rates is not constructive in a historical context; neither are falling global growth projections. Headline valuation is modestly compelling.


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