Rising costs, prices and wages are weighing on business profitability. Higher interest rates and a more hawkish Federal Reserve means slower growth and a possible recession, making stocks even less attractive, said Fiona Cincotta, financial markets analyst at City Index.
On 13 June, Wall Street’s equities fell 3.9% to close at its lowest level since January 2021. The move left the index more than 20% below its January 2022 peak, a slide often identified as a bear market.
Despite several headwinds for the asset class and remaining concerns over unattractive valuations, experts that spoke to Investment Week are still seeing some pockets of opportunity within some sectors of the market.
Monetary policy uncertainties
US inflation soared to 8.5% year on year in March, a 40-year high. After cooling in April to 8.3%, the consumer price index rose to 8.6% in May, beating economists’ expectations and representing the highest increase since 1981.
The recent run-up in prices has kept investors on edge about what it means for the Federal Reserve amid speculation that it may need to act even more aggressively.
“The stock markets have been flip-flopping over whether the central bank has a hold on the situation or not. Some days there is optimism the Fed can rein in inflation without causing a recession helps stocks high. On other days, there are fears the Fed cannot tame inflation without a recession, which pulls stocks lower,” said Cincotta.
US inflation up to 8.6% in May
The Federal Reserve raised interest rates by 25 basis points in March and 50 basis points in May, with a further hike of 50 basis points widely expected in June and again in July.
“If the Federal Reserve thinks inflation is starting to cool back towards its 2% target, we could expect a less hawkish stance from the US central bank, which could benefit stocks,” she added.
The Morningstar US Large Cap Equity index is down 8.45% year-to-date in GBP terms, compared to Developed Europe Equities which are down 6.32%, while UK Equities are up 1.98%.
Bumpy roads ahead for growth stocks
Sectors in the US stock market that have been leaders over the last decade have come to a sudden stop in terms of their outperformance of the broader market since the start of 2022.
Despite Big Tech and consumer discretionary stocks showing extraordinary growth in recent years, Felix Wintle, manager of VT Tyndall North American, believes that further downside is the high probability scenario for these names.
“Both have had iconic stocks that have propelled the outperformance, FANG in tech and Amazon and Tesla in discretionary, but with these stocks correcting and, in some cases crashing, it is time to listen to the market’s message rather than hang on grimly to investment cases that have run out of steam,” he said.
According to Leslie Alba, associate director of equity research at Morningstar Investment Management EMEA, stronger competition and business model uncertainty has driven the downward revision of expected growth for some of the tech stocks.
“Nevertheless, some Big Tech names have strong balance sheets, good cash flow generation and high profitability; all characteristics of high quality companies. As a result, as valuations become more attractive, they could be good companies to own.”
Chris Metcalfe, CIO at IBOSS, argued that the best IT companies still “do not look cheap” and many of the newer and often smaller working from home winners “have questionable business models in a rate rising environment”.
“In regards to the consumer discretionary sector, we believe the US economy, which is almost certainly in better shape than the Euro area, will face severe headwinds as inflation proves more intractable than is currently being priced into valuations,” he said.
Therefore, Metcalfe’s first fund pick is M&G North American Value, which is significantly predicated on a value remit and has sizable underweights in the information technology and consumer discretionary sectors. The fund has returned 10.9% year-to-date, according to FE fundinfo.
Opportunities in ‘forgotten’ sectors
An area of the market that, according to Wintle, has been somewhat forgotten over the last several years, but is performing better in these challenging market conditions, is healthcare, and pharmaceuticals in particular.
In his fund, Wintle owns three companies in the pharma space. One of the stocks he is particularly bullish on is Eli Lilly, which had its new weight loss drug Mounjaro approved last May. In a recent phase three trial, the drug was shown to decrease body weight by 22% in adults.
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“That is a big number, and no other drug has shown anything like that before, and we believe it will become a multi-billion dollar therapy,” he said.
Alba is also finding opportunities in healthcare and staples, which she considers more attractively priced and have also “historically demonstrated defensive characteristics in periods of market stress”.
“With continued uncertainty around inflation, interest rates, economic growth and the war in Ukraine, it is important to ensure that our portfolios remain robust across a wide range of economic and market scenarios,” she said.
“Investors should remember that valuations matter. Our research shows that holding companies that have a margin of safety and are trading at prices below their intrinsic value provides some protection.”
Metcalfe continues to allocate to global income funds, which in some cases have substantial US positions, in a bid to capture the ongoing potential of US dividend-paying companies.
“The valuations of these stocks never reached the dizzy heights of their growth peers, and therefore we feel that gives them more relative downside protection should the US economy falter in the coming months,” he said.