Sectors to Watch in a Range-Bound Equities Market
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.
