Leading indicators point to a fundamentally improving economy,
modest inflationary pressures have replaced deflationary concerns,
and unemployment continues to fall. We expect the Federal Reserve
to raise short-term rates at least two more times this year. This return
to a more normal interest rate environment is a positive, given that
increased rates would be a response to a healthier economy.
Still, it is important to acknowledge that many “hard” economic
measures (such as government-reported retail sales and durable
goods manufacturing) have been less robust than readings for “soft”
economic measures (such as surveys of business and consumer
confidence). We believe fiscal policy implementation can greatly
influence how the soft data carries over to hard measures. If the
administration can coalesce enough support to advance some of its
pro-business policies, even conditional wins could help bridge the disconnect between soft and hard data, thereby catalyzing stronger
growth and the animal spirits in the economy.
As deflation fears transition to reflation confidence, we see positive
and pervasive implications for active stock picking. Since 2008, the
“wall of worry” has been that low interest rates signal deflation risk,
which is negative for earnings. Stocks have been dominated by these
macro (or top-down) concerns rather than company fundamentals,
which is shown in Figure 2. This chart highlights the high and unusual
correlation across stocks post-2008, which is in contrast with much
of the post-World War II period when these fears of systemic risk
did not exist. It is striking that correlations have recently fallen into
the pre-2008 range. This confirms our view that deflation fears are
subsiding, with positive implications for active management. We
think corporate fundamentals will trump macro fears as investors gain
confidence in sustained and stable global GDP growth.
In this environment, there are growth opportunities beyond defensive
growth sectors, including in consumer discretionary, industrials and
financials. The consumer discretionary sector is highly diverse but has
generally performed well on the strength of U.S. consumption. Here,
we are emphasizing higher quality areas, while maintaining a highly
selective approach to struggling areas, such as retail. In industrials,
we are favoring companies that can benefit from recovering U.S.
GDP growth and potential tax reforms (including railroads and
machinery), as well as beneficiaries of increased defensive spending.
In the financials sector, we see opportunities multiplying as regulatory
pressures ease, the economy improves, and interest rates rise over
time. We are overweight banks and have exposure to capital markets.
Our positioning also reflects our long-standing constructive view
on technology, including high-quality names in the internet and
software industries. Meanwhile, within health care, a difficult political
setting is offset by specific opportunities. Contrary to common
perception, many health care companies are no longer growth
businesses in the absence of meaningful pricing power. This is a
broad risk that is unlikely to resolve quickly as the central problem in
the U.S. health care system remains excessive cost. However, a large
part of this risk is reflected in stock valuations and the sector is highly diverse. Managed care and medical technology are two industries
where we see attractive upside.
FIGURE 2. COMPANY ANALYSIS: A RETURN TO RELEVANCE
Source: Empirical Research Partners Analysis, National Bureau of Economic Research. Recessions
indicated by shaded areas.