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Policies and Rates May Not Slow This Economic Train
In our Wealth Outlook for 2024, we observed that in 2023 “rolling recessions” across portions of the US economy would “roll off” in 2024. The idea that the US economy was already enduring major recessionary conditions anticipated by the long-inverted yield was novel. Now we are faced with a second novel possibility: perhaps all the rate increases and restrictive monetary policy on the past 18 months won’t slow the economy in 2024 as much as we thought.
Some Sectors Have Surged, Some Have Yet to Catch Up
When we look at sector performance since late ‘23, we can see that investors have already begun to price in elements of a cyclical recovery. But like most of the post-pandemic period, this is not a typical cyclical rebound. While sectors tied to manufacturing and housing have surged, other traditionally high beta segments remain in the doldrums.
The Industrial Sector is at a Gallop
Large-cap US industrial sector shares have already risen 21% since October 27 and trade at 21x estimated EPS for 2024. US small and mid-cap industrials having risen just as rapidly over the same period.
All this while shares in other regions, foremost being China, lag.
Summary
In the US, the Institute for Supply Management New Orders Index showed expansion in January for the first time since August of 2022. While still subdued, US manufacturing production increased as 2023 ended. And there are signs the most impacted sectors are bottoming earlier. This has portfolio implications from interest rates to equity selection across regions.
The signs of recovery for production and trade are mild but have come earlier than expected. The US, Germany and even China all saw at least a modest export gains near year-end ’23. Performance over the past 12 months suggests that Industrials are pricing in an earlier, more robust recover than we thought likely. US small and mid-cap industrials having risen just as rapidly over the same period. We believe medical technology is another area that may benefit from broadening in earnings. The segment remains under-appreciated by the market while also exhibiting low sensitivity to interest rates (see chart).
Portfolio considerations
This may be the wrong time to give up on select non-US equities. We expect market returns to broaden out not just at the sector level but also geographically. Global shares that are benefiting from the same secular growth trends should be rewarded like their US peers. Moreover, a further recovery in global manufacturing and trade could benefit industrials in Japan and Europe, which have lagged their US counterparts. While much further off, an eventual Chinese recovery may also benefit its closest trading partners in Asia and Europe.
Source: Bloomberg, Feb 8, 2024.
Policies and Rates May Not Slow this Economic Train
On the inflation front, our data sources point to a 2% inflation rate later in 2024. US goods prices are near deflation levels as falling import prices for finished goods and materials are benefiting US industry. In real estate, rear view mirror housing data and backwards calculation methodology for the US Shelter CPI suggest further downward surprises for these core inflation measures over the year ahead. Investors worried that the US Federal Reserve will not lower rates should be mindful that it is unlikely the US can sustain its galloping January employment growth (+353,000, but -2.6 million prior to seasonal adjustment).
Similarly, for the “recessionaires,” there is also no reason to expect a sudden aggregate employment contraction that would cause the Fed to ease rapidly. Some cyclical shares are already priced (or even over-priced) for a stronger-than-expected macro environment. Others face ongoing property-related risks in the US and China. We cannot count on a big bond rally bailing out the market’s most rate-sensitive sectors. The eventual broadening in markets will be led by corporate earnings but will benefit more slowly from falling rates and a yield-curve normalization.
Some Sectors Have Surged, Some Have Yet to Catch Up
When we look at sector performance since late last year, we can see that investors have already begun to price in elements of a cyclical recovery. But like most of the post-pandemic period, this is not a typical cyclical rebound. While sectors tied to manufacturing and housing have surged, other traditionally high beta segments remain in the doldrums. there has historically been a close relationship between manufacturing sentiment and outperformance of Industrials versus defensive sectors like Consumer Staples. Performance over the past 12 months suggests, however, that Industrials are already priced for a fuller cyclical recovery. Homebuilders, another highly cyclical group of stocks, have surged since mid-2022 despite a doubling in mortgage rates. Structural demand for housing, coupled with a shortage of supply and easing of cost pressures, have led to a de-coupling of the typical relationship between home builders and interest rates. Again, we see a cyclical recovery already priced into shares.
Last year, the healthcare sector underperformed the broader market by 24%1 (+2% VS +26% for the S&P 500), impacted by a perfect storm of US drug pricing reform, COVID hangovers and disruption from the excitement related to GLP-1 weight loss drugs. As we highlighted in our recent CIO Bulletin, we now view health care innovation to be on “sale.” The healthcare sector is highly diverse. Within the sector you will find defensive value in large cap pharma and highly speculative growth in small cap biotech. Straddling these two extremes are medical devices and life sciences tools companies, who focus on the equipment and tools needed to operate a hospital or undergo a drug trial. This group tends to be somewhat more cyclical than pharmaceuticals and is well-placed to benefit from continued normalization in the health care sector post-COVID. Similar to how solid earnings growth have been realized in our high conviction investments - global semiconductor equipment and cybersecurity - we believe medical technology is another area that may benefit from broadening in earnings. The segment remains underappreciated by the market while also exhibiting low sensitivity to interest rates.
The Industrial Sector is at a Gallop
Markets are beginning to see results from the higher growth/lower inflation combination. Large-cap US industrial sector shares have already risen 21% since October 27 and trade at 21x estimated EPS for 2024. There has been a strong historical relationship between manufacturing sentiment and the outperformance of Industrials versus defensive sectors like Consumer Staples. Performance over the past 12 months suggests that Industrials are pricing in an earlier, more robust recover than we thought likely. US small and mid-cap industrials having risen just as rapidly over the same period.
