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Stephanie Link, Chief Investment Strategist and Portfolio Manager, Hightower

Portfolio > Economy & Markets > Stocks

Sectors to Watch in a Range-Bound Equities Market

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What You Need to Know

  • Higher interest rates will lead to slower economic growth and potentially, rising unemployment, which could prompt a recession.
  • A strong dollar gives U.S. companies greater buying power but makes U.S. goods and services more expensive overseas, potentially weakening demand.
  • The energy sector is hot due to tight supply, pricing power, strong free cash flow and earnings.

Equities remain choppy, stuck in a trading range as investors grapple with multiple unknowns, including how much the Federal Reserve will need to raise interest rates, when inflation will start to slow down, the impact of a strong dollar on earnings, and uncertainty about the resilience of U.S. consumers.

Consumer and producer prices are still white hot amid high demand and persistent supply shortages. For the Fed to go from 9.1% year-on-year CPI inflation to its 2% target, it will have to significantly jam on the brakes.

This will lead to slower economic growth and potentially, rising unemployment, which could prompt a recession — an outcome that is looking increasingly likely for 2023. The latest inflation data confirmed that the Fed still has considerable work to do, but whether it raises rates 75 or 100 basis points at upcoming meetings is not as material as when it will slow its pace of rate increases, hopefully at some point this fall.

On the bright side, the University of Michigan sentiment index came in a little better than expected for July, at 51.1. Retail sales were also better than expected, up 8.4% year on year, though down slightly on the month adjusted for inflation.

I believe the consumer is stronger than people think — they currently have $2 trillion in money market accounts and the job market remains tight, with over 11 million job openings available. This, along with wage inflation, supports the thesis that we still have some pent-up demand. 

The last time inflation was this high, in 1981, P/E multiples were in the single digits. We are seeing opportunities surface in the market now, with 105 names in the S&P 500 trading below 10x times forward earnings. 

Analyzing Inflation

In the latest CPI report, we saw inflation particularly hot in food and energy. Rental costs, roughly 32% of total CPI, also continue to increase due to low vacancy rates, higher mortgage rates forcing potential homeowners to rent, and the result of record home appreciation driving higher rental costs. Rising wages due to tight labor markets also continue to drive higher prices. 

Despite a consumer shift from goods to services, goods inflation continues to be a driver of overall inflation. Within CPI, food at home was up 10.4% year on year, energy was up 41.6% and all other commodities were up 7.2% versus a year ago. On aggregate, consumer commodity prices were up 13.6% year on year and services prices were up 6.2% versus a year ago. Similar trends are seen for producer prices, with goods up 17.9% on the year and services up 7.7%. 

Services are a larger component of GDP and prices tend to be stickier, driven in part by rising wages and rents. Commodity prices have also been sticky as persistent shortages in energy and agriculture are a growing risk to the global economy. 

The Strong Dollar’s Impact on Earnings

The U.S. dollar index is at a 20-year high, with the U.S. currency buoyed by the impacts of inflation, higher interest rates and geopolitical instability. U.S. companies that import from overseas suppliers can do so with greater purchasing power, potentially easing some of the higher inflation costs. But a stronger dollar also makes U.S. goods and services more expensive for non-U.S. buyers, potentially weakening demand for U.S. exports. 

U.S. companies with sales overseas will be adversely affected by the U.S. dollar conversion rate, and this is expected to broadly impact global companies in their Q2 earnings. Microsoft, which earns more than one-third of its profits from overseas, warned in early June of foreign exchange headwinds as it lowered its earnings guidance. Other companies such as Coca-Cola, Medtronic and Salesforce have shared similar warnings. 

Q2 earnings growth for S&P 500 companies is expected to be led by energy, and dragged by financials. Overall, the S&P 500 is projected to grow earnings 4.8% year on year and grow sales 10.6%.

Excluding financials, earnings are expected to grow 12.3% year on year, and sales to grow 12.8%. Energy is expected to account for 45% of S&P 500 sales growth in Q2. We’ve regularly stated earnings downgrades as a market risk, but so far, downgrades have lagged the historical average pace. 

Themes across financials have included lower investment banking revenue, strong trading revenue, and setting aside additional reserves for potential loan losses and impairments. Year-on-year earnings fell across J.P. Morgan, Morgan Stanley, Citigroup and Wells Fargo, which all reported last week. Citigroup was the only name to beat earnings expectations. The one bright spot from the earnings was that net interest income and net interest margins rose more than expected (due to higher yields) with several raising estimates overall.  

Finding Opportunity in an Uncertain Time

I am overweight energy, due to tight supply, pricing power, strong free cash flow and earnings. Consumer discretionary has been significantly beaten up in recent months, with many key names down 30%, so I’m seeking out quality companies at attractive prices. I look for strong management teams and balance sheets, as well as dominant market share.

At the same time, I am market-weight health care, owning select names where I have strong conviction — well-run companies with size and scale that are the antithesis of cyclical.

Sectors where I am underweight include technology and communication services, not only because they are over-owned, but many also over-earned during the pandemic when demand was skewed by stay-at-home shopping trends. In many cases this has led to double-ordering, which can have a significant negative impact on a company’s balance sheet.

When looking to buy any company in this space, such as social media names, I am highly focused on the fundamentals — earnings, free cash flow and number of advertisers as well as daily average users —  and look for size and scale. 

Another sector where I’m underweight is consumer staples, which as a group is expensive right now relative to their earnings.

It’s a frustrating time for equity investors. We are stuck in a trading range, awaiting signs that the Fed’s tightening policy is starting to have some impact.

Inflation probably has peaked, but it’s still very, very high and the Fed isn’t even at neutral yet. At times like these, we encourage advisors and investors to focus on the fundamentals, seeking high-quality companies at attractive valuations.

Stephanie Link is chief investment strategist and portfolio manager at the national wealth management firm Hightower Advisors LLC. She leads the firm’s Investment Solutions Group, which specializes in outsourced chief investment officer services, model portfolios, separately managed accounts, investment research and due diligence for Hightower Advisors LLC. Follow Stephanie on LinkedIn and Twitter @Stephanie_LinkRead her regular market insights here.


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