Tuesday, August 13, 2019

Sector Inspector: Our Macro Framework for US Markets and Why We (Still) 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 supports diversification, and believes 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 S&P 500 at 16.8x forward earnings as within a range that represents reasonable value.

  • We believe the US consumer is healthy 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.
  • Current US trade and national security policy bring headline risk to stocks and operational risk to companies. This covers tariffs, but also withdrawal or agitation on other fronts (e.g., Iran).
  • The United States is 15 months away from our next Presidential Election, and we expect 2020 campaign rhetoric to impact markets. In general, we assume enacted legislation will be less impactful than initial policy proposals might suggest.
  • We assert that the Fed is acknowledging a global slowdown, and is ready to respond. In cutting rates in July, we believe the Fed has built upon its ‘dovish pivot’ from January. Markets expect two or three more rate cuts in 2019.
  • 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 15.1x forward earnings as highly attractive given the long-term growth potential of the sector. Although the group operates globally (particularly pharma and medical tech), demand is not cyclical and companies are not particularly sensitive to a global supply chain. Demographic trends add resiliency to the domestic demand outlook.

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 in healthcare 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. We prefer market leaders with the capital to invest to defend (and grow) their business in an era of fee compression, disruption (e.g., artificial intelligence), and rising cyber security/data/privacy demands.

At 11.7x 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). The recent Fed stress test cycle was constructive, in our view, and a long-rumored revamp to the Volker trading rule is gaining traction.

Energy: A feedback loop of growth fears and falling oil seems to be driving the YTD laggard, but we see an opportunity to be contrarian in Energy. Valuation remains compelling for us at 14.9x forward earnings, even though profit expectations have slipped. We are comfortable being patient with leading companies in the sector given a shift toward cash returns, and we remind investors that our call here is made through the lens of long-term portfolio construction.

Energy is historically the least correlated S&P 500 sector, is typically strong late-cycle, and can be a geopolitical hedge. These items may not all factor into returns over the next few years, but directionally they are characteristics we like.

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 theme.

Utilities: Our concern with Utilities is long-term expected return if entering positions at nearly 20x forward earnings, or as much as 30% above average valuation 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 or economic cycles, and is relatively insulated from today’s national political theatre.

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 believe both the Trump Administration and the Democratic nomination process bring headline risk to the sector.

Communication Services: We like Comm. Services as a play on consumers, but politics is a stealth risk with search and social media both part of the sector. Group includes old Telecom (deep Value) and some leading ‘tech’ growth companies.

Consumer Discretionary: Exposure to the US consumer is appealing, but valuation is expensive and trade concerns are worsening with new tariffs aimed at consumer goods. Disruptive risk to traditional retail is a persistent concern.

Industrials: Sentiment and valuation seem reasonable, and avoiding budget sequestration bodes well. That said, the sector in aggregate is exposed to rising cost pressures, global growth projections, and fading US transports data.

Real Estate: We worry about long-term expected return from current levels. That said, we like the US-centricity and see Real Estate as the most direct way to play for even lower rates. Industry selection within the sector is important.

Materials: The pivot lower in interest rates is not constructive in a historical context, though lower oil should be a net positive. The spin-offs of DowDupont could generate interest.


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