Thursday, December 6, 2018

Sector Inspector: Our Macro Framework for US Markets and Why We 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: Consumer Discretionary to LIKE from Neutral; Utilities 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 overall market, now at less than 16 times forward earnings, as modestly attractive on valuation.

  • The G-20 meeting between Trump and Xi Jinping was not an inflection point regarding Trade, in our view. The current trajectory of US trade policy remains destructive for financial markets, and parameters could worsen further before they improve.
  • 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.
  • Energy prices have been volatile. Oil collapsed by nearly a third while natural gas rallied by half over the last couple of months. Discrete items such as strong production, Iranian-import waivers, and global growth fears have contributed to the move. 
  • Evidenced in part by higher interest rates and wider credit spreads, financial conditions have tightened. We refrain from projecting the path of interest rates, but do believe the prudent move is to eschew weaker companies and favor stronger balance sheets.
  • We believe the US economy is strong, particularly the US consumer. Constructive points include employment, manufacturing data, and both consumer and business confidence. We do not necessarily expect US growth to outpace the rest of the world in aggregate, but do believe the outlook for our domestic economy is more resilient.

We Like: Consumer Discretionary, Financials & Energy

Consumer Discretionary: Our core thesis in Consumer Discretionary is an improved view on valuation and a strong US consumer. We see consumer spending as one of the more dependable facets of the current economic backdrop given low unemployment and rising wages. The swoon in oil bodes well here also. The sector may not appear cheap at 19.5x forward earnings; however, the sector is one of the cheapest versus historical average if adjusting for expected growth.

We do acknowledge some challenges for the sector. The uptick in interest rates has put a damper on Autos and Housing (and sentiment tied to both). Some pockets of retail are overleveraged and face disruption, and goods manufacturers are likely to grapple with cost inflation next year. 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. We believe many of our qualitative reservations are already priced into shares (sector down 10% since mid-September).

Financials: We like valuation in Financials at just 11.5x forward earnings expectations, which is the lowest the group has been since late 2012. Flattening of the yield curve could remain a near-term headwind, but reservations here are offset by structural positives. Financials 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). In summary, we believe prevailing fears present opportunity for long-term investors.

Financials also benefit from broad economic growth, as facilitators of both investment and consumption. We believe the group is well-positioned within the growing US economy. Financials are not unique in this regard, but we like them versus other economically sensitive sectors as they are not sensitive to rising costs for physical inputs.

Energy: Energy stocks have been the worst performing sector of Q4, having fallen 15% since October 1, and we are inclined to look for value here. Energy and 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. Across production companies, we encourage a bias toward large-cap high-quality opportunities that can withstand higher borrowing costs. Separately, we believe some of the infrastructure businesses (e.g., pipelines) are more resilient than volatile stock prices might imply.

At just 14.0x forward earnings, Energy’s valuation is not very demanding. Oil price declines could weigh on expectations for 2019, although we believe this process is already unfolding. Energy is expected to grow earnings faster than any other sector this year, so the optics of trailing valuation should improve over the next few quarters.

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 18.5x forward EPS as too expensive for a low-growth sector primed for disruption, particularly with the broader market having re-priced lower in the second half of 2018.

Due to both high leverage and the group being used for equity income, Staples are sensitive to higher interest rates and tighter financial conditions. Staples have no guarantee of recouping costs from customers. 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.

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

Technology: Valuation has improved and is reasonable, but 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: Our only real reservation is too much positive sentiment, though the YTD best sector could see rotation in early 2019. Well-positioned to defend margins vs. cost pressures; good outlook for M&A and capital return.

Communication Services: We refrain from taking a strong stance toward Comm. Svcs., electing to let the new sector mature. Sector composition is barbelled, with old Telecom (deep Value) and some of the market’s leading growth names.

Industrials: US-centric industries such as trucking and rails seem quite healthy, although the sector in aggregate is highly exposed to rising cost pressures, the global trade order, and more volatile growth projections abroad.

Utilities: Our only reservation is relative valuation, insofar as we believe there will be better timing to focus on the sector. A contrarian play, Utes are our favorite defensive sector. We prefer utilities with stronger growth prospects.

Real Estate: Financial tightening is our core concern, whereas strong US economic momentum serves as an offset. We believe industry selection here remains highly important (e.g., malls vs. single-family housing vs. data centers, etc.).

Materials: Higher interest rates have portended well historically, but this time could be different as concerns over the pace of global growth are percolating. Headline valuation is compelling.


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