Focus on Fundamentals, Not the Fed

Text transcript

Paul Roukis, portfolio manager, Rothchild & Co.

In our view, the stock market recovery in the fourth quarter and thus far in 2023 has been largely sentiment driven. A peak-inflation thesis supported by the notion the Federal Reserve will take its foot off the monetary tightening gas pedal. And The Fed’s preferred inflation measures have shown meaningful retracement off of last year’s highs, and if this rate of change continues, it will provide the Fed with cover to pivot in the tightening campaign. To this point, investors have been focused on the marginal policies of The Fed, as well as the policies of other central banks, rather than the underlying operating fundamentals of companies, which have deteriorated in recent months.

As we’ve experienced in recent market cycles, The Fed’s influence on investor sentiment, the real economy, and the capital markets has grown exponentially since the great financial crisis, coinciding with a buildup of its balance sheet. Corporate profits and the underlying cash flows of businesses are what drives stock prices in our view. And the outlook here that is on corporate profits has deteriorated in recent months and disconnected from investor enthusiasm. To us, the best proxy for corporate profits is probably measured by the S&P 500. In recent months, we have seen 2023 profit growth be revised downwards from about plus 10% to a low single-digits rate. So, for the S&P 500, consensus EPS expectations are now gravitating to $200/$225 in the aggregate for 2023.

Clearly, there are sensitivities to economic growth and the $220-plus number would likely prove optimistic in a mild to hard recessionary scenario. I think reality is setting in as companies report fourth quarter earnings. For many, it’s getting tougher to pass along price hikes to their customers as the cycle matures. There’s also stress forming at the consumer level given inflationary pressures for necessities like food, shelter, and energy. This also happens to be coinciding with excess savings being run down from pandemic-related stimulus programs. Just keep in mind, the U.S. economy is 70% or so driven by the consumer. So, while jobs are plentiful, which is a savior, these issues all have an influence on discretionary spending. I would add though that while the bias to corporate profits is downward, it’s not all negative news. The dollar is weakening, which was a sizable relative headwind last year. Europe looks less likely to experience a recession with a little luck from warmer weather this winter, and China is reopening from Covid shutdowns.

Following a year where growth stocks underperformed value stocks by over 20 percentage points, we as a team have found more opportunities in the technology sector of late. In essence, we believe the broad-based selling and growth stocks last year has resulted in one of those situations where the baby may have been thrown out with the bathwater. With that said, earnings continue to be revised downwards in technology. So, we’ve been patient and selective with respect to adding. Interestingly, the index that our strategy benchmarks to, the Russell 1000 Value Index, has seen many more growth stocks become constituents during the most recent annual rebalance. Traditional growth stocks, like Meta, Alphabet, salesforce.com and AMD, are now bigger weights in the benchmark than the likes of the traditional value stocks like IBM, Hewlett-Packard, and Intel. So, our benchmark has changed very dramatically in recent years.

One stock I would talk about is PayPal, which we initiated a position during the fourth quarter of last year. The stock declined by more than 60% last year, and as you know, PayPal is a dominant player in the digital and mobile payment space, areas of the market where competition is relentless from the likes of Apple, Google, and even the big banks to just name a few. We acknowledge the competitive risks here and understand that share gains may be difficult to sustain. The near-term outlook is challenging no doubt, but we also acknowledge that PayPal provides value to its merchant customers in terms of retention and transaction conversion, and new partnerships can help complement growth. So importantly, we think after a tough 2022, expectations for PayPal have been reset to reasonable levels. Management has a renewed focus on profitability. They have the resources to reinvest in growth, and at the same time they have the resources to reallocate excess capital to shareholders in the form of share buybacks. So, there’s real cash flow underlying this business at what we think is a reasonable valuation.

As investors, we tend to favour companies with secular growth biases within the value universe, and ones that trade at reasonable valuation multiples. So, by that I mean companies that have perceived sustainable competitive advantages, also ones that have the resources to reinvest in their business models while at the same time enjoying scale benefits. Some examples outside of technology that we could talk about include, in energy, oil field services company, SLB, or Schlumberger, as it used to be called, a global powerhouse with the resources, the scale in digital applications. In financials, BlackRock comes to mind. A company that is high margin and has proven to be an effective gatherer of assets. Finally, in healthcare, we own Ensure UnitedHealthcare, which is a vertically integrated model that is hard to duplicate and offers cost advantages to peers.

While we are not fortunate enough to have a crystal ball to help with the economic outlook, I think it’s important to note that consensus expectations are for a mild recession in 2023. 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. We saw another 25-basis point increase by The Federal Reserve in early February. And this cycle also has the complication of quantitative tightening following the rapid buildup in The Fed’s balance sheet. So, it’s a lot of tightening to naively think a soft landing is guaranteed. The reality is that the full effects of this 400-plus basis points in rate increases has not been fully reflected in economic output just yet, usually a lagged-effect over 12 to 18 months.

Clearly, the sectors most sensitive to rate hikes, things like residential housing and commercial real estate, have seen expedited demand destruction due to the higher rates, but most other areas have proved resilient thus far. Is it just a matter of time? Maybe. But that is why a necessary ingredient in the economic recipe is continued inflation erosion. A move to 3% or possibly lower in the traditional measure of CPI while still above The Fed’s 2% comfort zone would provide flexibility for our central bank to alter monetary actions if the prior actions prove to be over killed.

Another key metric for all of us to watch is employment. The headlines of mass layoffs at some of the largest companies are not really reflective of the broader employment trends, at least not yet. A resilient labour market would go a long way to a soft landing.

This does not constitute investment advice or an offer or an invitation to buy any security, and that our opinions are subject to change.