Wednesday, April 10, 2019

Sector Inspector: Our Macro Framework for US Markets and Why We Dislike Utilities and Consumer Staples

Spencer Joyce, CFA
Author position
Vice President | Markets Analyst

The Investment Strategy & Research team of Hilliard Lyons, A Baird Company, supports you and your Wealth Advisor with investment guidance to 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: Utilities to DISLIKE from Neutral.

Our Current Macro Framework for US Markets

Many themes and opinions impact our sector views; several are detailed below. We view the S&P 500 at 16.7 forward earnings as within a range that represents fair value.

  • We believe the US economy is strong, particularly the US consumer. Low unemployment, rising wages, and continued job growth underpin this view. Anomalies tied to the government shutdown seem to be unwinding, and we view the US growth outlook as more resilient than for most of the rest of the world.
  • Despite waning global growth expectations across the first quarter, oil, copper and iron ore prices have been resilient. Forced oil supply cuts in Libya, Venezuela and Iran seem to be helping balance supply and demand.
  • Following a Fed ‘pause’ in March, the yield curve briefly inverted (3-mo/10-yr relationship). Futures suggest a rate cut by the Fed is more likely than a hike in 2019. In recent weeks, credit spreads have compressed, and rates have trickled lower.
  • US trade policy brings headline risk to stocks, particularly US multi-nationals. We believe stock prices largely reflect a constructive trade deal with China, while underestimating the possible impacts of tariff escalation with the European Union, a shutdown of the US/Mexico border, or the potential for NAFTA to be re-reopened later this summer.
  • We are cognizant of rising cost pressures for companies, particularly rising wages and elevated transit costs.

We Like: Consumer Discretionary, Financials & Energy

Consumer Discretionary: We like Consumer Discretionary as a play on the US consumer. We see domestic consumer spending as one of the more dependable facets of the current global economy due to low unemployment and rising wages. Lower interest rates bode well for housing activity and auto demand, facets of the US expansion that have been somewhat uninspiring. The sector is not cheap, on average, at 20.9x forward earnings, but we nonetheless believe the qualitative narrative is demanding of investors’ attention.

We do acknowledge some challenges for Discretionary. Goods manufacturers are likely to grapple with cost inflation and could see headwinds from trade disorder. Incremental benefits to consumers from cheaper gas prices and tax cuts are likely to be less in 2019 vs 2018, while pockets of retail are overleveraged and face disruption. That said, the sector is large, with varied industry verticals, and there are lots of companies with resilient operational and financial positions.

Financials: The brief yield curve inversion is not necessarily constructive for the Financials in a historical context, but a less active Fed is supportive of the US economy, and tangentially the economically-sensitive Financials sector. Tight corporate credit spreads and lower interest rates are supportive of potential M&A, which could be a catalyst.

We believe current valuation adequately reflects a range of concerns, from the yield curve to shaky global growth. At just 11.5x forward earnings expectations, long-term risk reward is favorable, in our view. Balance sheets are improved from the prior economic 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)

Energy: The cycle of lowering expectations due to collapsing oil prices in 2018 wound down in March. But the cycle of re-revising estimates higher based on commodity moves this spring will likely last through Q1 earnings season. At 16.8x forward earnings, Energy’s valuation is already undemanding. More broadly, Energy holds a low correlation with the market, which makes it intriguing to us after a strong and mostly broad move higher for stocks in the first quarter.

In general, we prefer Energy companies with stronger balance sheets and diverse business interests that could be reasonable long-term core holdings. Separately, we see pockets of value in pipelines.

We Dislike: Consumer Staples & Utilities

Consumer Staples: Consumer Staples are usually lower-margin businesses, which leaves the sector lesser-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 18.9x 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 is in structural decline. Consumers are increasingly looking for niche/super-premium brands, or ‘off brand’ products of improved quality. A strong consumer has positive general implications for Staples, but we believe there are better ways to leverage this trend.

Utilities: Low interest rates do not push Utilities higher (what we have now), but rising rate expectations push them lower. The Fed has suggested it will leave rates unchanged this year, although futures imply cut(s) are probable. Given our constructive economic views, we see the market as too dovish, which makes us wary of the sector at 18.4x forward earnings expectations. Our call is not aggressively bearish, but we believe it may be prudent to de-emphasize the group.

Offsetting our tactical view somewhat, we still like Utilities’ fundamental outlook. The US-centric sector probably holds the most resilient near-to-medium term forecasts, and utilities are not particularly sensitive to most federal politics.

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 like the sector as a play on consumers, but remind investors that stock selection is highly important. Sector makeup is barbelled, with old Telecom (deep Value) and some leading ‘tech’ growth companies.

Industrials: We worry the sector may have gotten a bit ahead of itself due to optimism surrounding a potential China trade deal. The sector in aggregate is exposed to rising cost pressures and global growth projections.

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, but firming commodity prices are better. Headline valuation is modestly compelling, and the spin-offs of DowDupont could generate interest.


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