Monday, June 10, 2019

Sector Inspector: Our Macro Framework for US Markets and Why We Like Healthcare, Financials & Energy

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: Healthcare to LIKE from Neutral; Consumer Discretionary to NEUTRAL from Like.

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 16.6x forward earnings as within a range that approximates reasonable valuation.

  • We believe the US consumer is strong and the US economy is growing. Low unemployment, rising wages, and steady job growth underpin this view, though tariff rhetoric seems to be curbing business confidence and private investment. We view the US growth outlook as resilient relative to the rest of the world.
  • Current US trade policy (and national security policy), specifically the threat and use of tariffs, represents operational risk for companies and headline risk for stocks. Some optimism for a speedy China deal has likely been removed from the market, but threats toward Mexico due to immigration policy underscore the idea that instability can percolate from anywhere at any time.
  • Treasury yields continue to fall, and interest rate cuts by the Federal Reserve look increasingly likely. Futures suggest three cuts in 2019, or 75 basis points in aggregate.
  • Portions of the Treasury yield curve remain inverted. We respect this economic cycle indicator directionally, but view it as a poor tool for timing markets. We also see some uniqueness to this cycle due to quantitative easing.
  • We are cognizant of rising cost pressures for companies, particularly rising wages, tariffs and elevated transit costs.

We Like: Healthcare, Financials & Energy

Healthcare: We believe political rhetoric has generated an opportunity for long-term investors to focus on Healthcare. We view valuation of 15.4x forward earnings as highly attractive given the long-term growth potential of the sector. Roughly 10,000 Baby Boomers turn 65 in the US each day, which adds resiliency to the domestic demand outlook. The sector operates globally (particularly pharma and medical tech/devices), but demand is not cyclical and companies are not particularly sensitive to a global supply chain. Rising labor and transit costs are inconsequential concerns.

The main headwinds we see for Healthcare are political. Policy concerns in the US, both real (regulatory changes or Congressional action) and perceived (election rhetoric) could weigh on sentiment indefinitely. That said, status quos of healthcare frameworks are notoriously difficult to upend, and consolidation/integration within the sector has created a group of companies that we believe are fairly well-equipped to grapple with incremental change. With this in mind, we believe long-term investors should consider the group while multiples are under pressure and the sector is out of favor.

Financials: The entire rate regime, from an inverted yield curve to persistently ‘low’ interest rates, is not necessarily constructive for Financials. That said, the group has shown an ability to adapt, execute and grow across this long but tepid economic expansion, and low rates could help M&A activity emerge as a more sustainable catalyst.

At just 11.8x 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). Structurally, we prefer market leaders with the capital to invest to defend (and grow) their business in an era of fee compression, technological disruption (e.g., artificial intelligence), and rising cyber security/data/privacy demands.

Energy: Fears over the pace of global growth seem to be overshadowing stable-to-positive trends in expectations, which we believe has presented opportunity in the space. The blended (2019/2020) 12-month forward EPS estimate for the S&P Energy sector bottomed in early March, and has been rising for most of Q2. We like valuation at 14.9x forward earnings and the idea of adding a little to a group that has historically been strong late in economic cycles.

In general, we prefer Energy companies with stronger balance sheets and diverse business interests that could be reasonable long-term core holdings. Separately, we continue to 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 19.5x 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: Our concern with Utilities is long-term expected return if entering positions at 19.2x forward earnings, which is 20%-30% above long-term averages (depending on timeframe). We are not asserting the group is mispriced right now given low interest rates and shaky global growth, but we do anticipate a better opportunity to focus on the sector.

Offsetting our tactical view somewhat, we still like Utilities’ fundamental outlook. The US-centric sector is not sensitive to tariff and trade policy, and there are still plenty of growth prospects tied to improving domestic infrastructure.

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

Technology: Tech generates more of its sales abroad than any other sector while relying on a global supply chain. We continue to believe the Trump Administration represents outsized risk to this sector.

Consumer Discretionary: Exposure to the US consumer is appealing, but valuation is relatively full given some exposure to trade concerns. Regulatory developments for Amazon could impact sector-level optics in the near term.

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: Sentiment for the sector seems more balanced; valuation has come down a bit but approximates ‘fair,’ in our view. The sector in aggregate is exposed to rising cost pressures and global growth projections.

Real Estate: Similar to Utilities, we worry about long-term expected returns given valuation, but do like the US-centric exposure. We believe industry selection is 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, and headline valuation is not particularly cheap. The spin-offs of DowDupont could generate interest.


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