Focus on fundamentals, not the Fed

Investors have focused too much on inflation and central bankers’ response rather than on deteriorating company fundamentals, a U.S. equities manager says.

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Paul Roukis, portfolio manager at Rothschild & Co. Asset Management U.S. in New York, said the stock market recovery this year has been largely sentiment driven, as investors look for signals that the U.S. Federal Reserve will end its rate-hiking cycle.

“The Fed’s influence on investor sentiment, the real economy and the capital markets has grown exponentially since the great financial crisis,” Roukis said.

But stock prices are driven by corporate profits and cash flow, Roukis said, and in recent months, profit growth has been revised downwards. 

“I think reality is setting in as companies report fourth-quarter earnings,” he said.

Not only is it becoming more difficult for companies to pass along price hikes to their customers, but stress is also forming at the consumer level given inflation’s effect on food, shelter and energy, Roukis said. Excess savings from pandemic-related stimulus programs have also declined, and although the labour market is showing no signs of slowing, these issues have affected discretionary spending.

But it’s not all negative, Roukis said. Looking forward, the U.S. dollar is weakening, Europe looks less likely to experience a recession and China is reopening from long Covid shutdowns.

Roukis has seen opportunities in the tech sector of late, after growth stocks underperformed value by more than 20% last year.

“We believe the broad-based selling in growth stocks last year has resulted in one of those situations where the baby may have been thrown out with the bathwater,” he said.

“With that said, earnings continue to be revised downwards in technology.”

In this environment, he said traditional growth stocks like Meta, Alphabet, salesforce.com and AMD are pulling more weight on the Russell 1000 Value Index than traditional value stocks like IBM, Hewlett-Packard and Intel.

One stock he currently likes is PayPal, a dominant player in digital payments that declined by more than 60% last year. Though it’s facing stiff competition from other tech players as well as traditional banks, Roukis said the company is able to invest in growth and the management is focused on profit. After a tough year, he said expectations have been reset to a reasonable level.

Roukis said he favours companies with secular growth biases that trade at reasonable valuations. Outside of technology, examples include SLB (Schlumberger Limited) in energy, BlackRock in financials and Ensure UnitedHealthcare in health care.

However, it’s important to note that consensus expectations are for a mild recession in 2023, Roukis said, and a soft landing is not guaranteed. The Fed raised its key interest rate by a quarter-point in early February, its eighth hike since March.

“Quite frankly, it is hard to find precedent in past cycles of the Fed orchestrating a soft landing, especially ones where short-term rates were raised by over 400 basis points in such a condensed time period,” he said. 

Sectors most sensitive to rate hikes, such as residential housing and commercial real estate, have seen a decline in demand, but so far, most other areas have proved resilient. Roukis said the full effects of interest rate hikes usually takes between 12 months and 18 months to fully work its way through the economy. 

Inflation falling to 3% or lower could provide flexibility for central banks to alter monetary actions, he said.

Lastly, looking at the labour market, Roukis said the mass layoffs at some of the largest companies are not reflective of the broader employment trends — at least not yet.  

In this case, “a resilient labour market would go a long way to a soft landing,” he said.

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