If the Federal Reserve has got its sums right, the US economy is about to lurch lower. The US central bank has made it clear that its priority is to tackle rising prices, and the US economy will have to take the pain. While inflation levels are dropping, rate cuts seem a distant prospect and the economy is starting to teeter.
The BlackRock Investment Institute has been suggesting that this trade-off would be necessary. There has been too much optimism, from both investors and the Federal Reserve, that growth could be sustained even as interest rates ticked higher. The economy may have made a stronger start to the year, but is likely to stall later in 2023.
Stock market valuations
There is a question mark over the extent to which stock market valuations reflect this potential weakness. To date, corporate earnings have been relatively buoyant. Companies have managed to sustain their profit margins and pass on higher input costs to their end customers. High employment levels have allowed companies to flex their pricing muscles, with little deterioration in volumes.
This has supported stock market valuations in the short term but, for some companies, this pricing power may fade as the recession bites. The savings pot accumulated by many households during the pandemic has largely been spent and consumers will have to rein in their spending as higher interest rates and inflation eat into their disposable income. As a whole, the US stock market is not reflecting this potential weakness.
In this context, we have been sticking firmly to quality companies with strong balance sheets, that don’t need to borrow to thrive and can weather the economic bad weather. These companies have their destiny in their own hands.
The importance of quality
Quality companies tend to have resilient pricing power, that should endure even as the US economy slows. Poorer quality companies may have managed to stretch their profit margins in the short term, but there are clear signs that volumes are declining as a result. This is unsustainable and companies may experience diseconomies of scale as a result.
We also need to pay close attention to valuations in this environment, technology can be subject to periods of over-valuation and we look at companies focused on high quality, well-established businesses, such as Microsoft, Cognizant and Cisco.
In healthcare we find more genuinely defensive companies than in, for example, the consumer staples sector. No one stops using healthcare because there is a recession. Valuations are more attractive. There are some areas, such as medical devices, where volumes are depressed because of Covid, which delayed routine operations. These operations are now coming back, but stock market valuations don’t yet reflect this revival. This is another hunting ground for us.
There are also areas that require caution: industrials, for example, used to be considered a cyclical sector, sensitive to the economic climate. However, the sector is currently trading at a premium to the (also expensive) consumer staples sector. The supply chain disruption around Covid created unusual patterns of demand, with customers double-ordering to ensure supply. The market appears to be extrapolating this demand out into the longer-term, but supply chain problems are now resolving.
We also see weakness in the real estate sector, which appears uniquely vulnerable to higher interest rates. A lot of projects started during Covid in a lower interest rate environment. These will come online into a weak demand environment and put pressure on the wider sector.
It has become fashionable to say that the US stock market is overvalued and doesn’t fully reflect the impending weakness in the US economy. There is some truth to this, but the US stock market has considerable breadth and variety. It is always possible to find great companies that can deliver strong growth through the economic cycle. Focusing on these businesses is likely to be more important than ever as the environment weakens in the second half of 2023.
Tony DeSpirito is co-manager of the BlackRock Sustainable American Income Trust. The views expressed above should not be taken as investment advice.