November 30, 2022

The Chief Investment Office (CIO) maintains a defensive bias in our sector positioning. CIO's most preferred sectors within US equities are consumer staples, energy, and healthcare, and least preferred sectors are consumer discretionary and materials.
See CIO's latest views on various equity sectors. (ddp)
US equities have been under renewed pressure since mid-August. Hawkish Fed rhetoric, higher interest rates, downward earnings revisions, and broader-than-expected inflation pressures have contributed to the recent weakness. In our view, the path from here will be largely driven by the Fed. The more that the Fed increases interest rates, the greater likelihood that economic growth slows and recession risks rise. Our most preferred sectors are consumer staples, energy, and healthcare, and our least preferred sectors are consumer discretionary and materials.
We maintain a defensive bias within sectors. Consumer staples’ earnings should be more resilient as macro headwinds persist. We believe valuations are reasonable. Despite outperforming, the energy sector has a very attractive free cash flow yield and should benefit from persistent underinvestment in energy exploration and production. Drug pricing reform removes an overhang on healthcare and provides earnings clarity. Consumer discretionary is at risk from a slowdown in consumer spending. A strong US dollar typically weighs on the performance of the materials sector.
Most preferred
Consumer staples: We think earnings for this defensive sector should hold up better than the market as economic growth slows. In addition, we expect further declines in the ISM Manufacturing index, which typically drives outperformance for this sector. We believe valuations appear reasonable given current macro headwinds and the sector’s defensive nature.
Energy: The long-term outlook for the energy sector looks favorable due to substantial underinvestment in oil exploration and production since 2014. This should limit oil supply growth and downside in oil prices.
Furthermore, substantial investment will be required to shift European gas imports to more reliable partners, which should benefit some US companies. Despite the strong performance of the sector, valuations are still attractive in our view, capital discipline has improved and the sector has a very attractive free cash flow yield. Companies are returning this cash to shareholders through buybacks and dividends, which should help mitigate downside risks in a recession scenario. Lastly, the sector seems to be reflecting an oil price of around USD 70-75/bbl, which is lower than spot prices.
Healthcare: Relative to its defensive peers, we believe valuations remain attractive, and the earnings outlook is favorable. Medical procedures are recovering as COVID-19 trends improve. Drug pricing reform in the Inflation Reduction Act (IRA) provides resolution to this longstanding issue for pharmaceutical companies which should drive greater earnings clarity and higher valuations.
Neutral
Communication services: The shift of advertising dollars to digital platforms should benefit the sector over time. However, digital ad spending seems to be slowing as the economic outlook cools. Competition in digital advertising, video streaming, and broadband is heating up as well.
The defensive nature of telecom companies (around 15% of the sector) may help offset some of these pressures in a downturn. Investors should be aware that the market-cap-weighted version of the sector is highly concentrated, with Alphabet and Meta accounting for almost 60% of the total.
Financials: The outlook appears balanced. On the positive side, Fed rate hikes should boost bank profitability, and loan growth has been solid. On the negative side, as economic activity slows, capital markets businesses may face incremental headwinds, and investors may be wary of investing in this economically sensitive sector when recession concerns are prevalent.
The sector tends to be highly correlated to the 10-year Treasury yield, although it has lagged the move higher in yields this year.
Industrials: The sector is unlikely to outperform as the ISM Manufacturing index, a gauge of business activity and sentiment, continues to decline, as we expect. Within the sector itself, however, we still think there are interesting opportunities. Defense companies should benefit from higher defense budgets in the years ahead. In addition, the infrastructure law should support nonresidential construction, while aerospace manufacturers and the aerospace aftermarket should benefit as travel continues to recover.
Information technology: Fundamentals remain mostly healthy, but the sector faces some challenges from supply dislocations and weaker demand for PCs and smartphones. Semiconductor demand is also slowing in some segments and this industry tends to be correlated with the ISM Manufacturing index, which will likely continue to fall. However, secular trends in cloud computing remain healthy, and enterprise IT spending is still good, although it appears to be slowing. Relative valuations are near post-dotcom highs.
Real estate: Fundamentals for the largest segments of the sector— wireless towers and data centers—remain solid, but the outlook for retail and office segments is more questionable. Concerns about oversupply in the industrial (i.e., warehouse) segment have also become more pronounced.
Utilities: The outlook for defensive sectors has improved based on tighter monetary policy and slowing economic growth. Still, within defensives, we prefer the consumer staples and healthcare sectors, which are both cheap relative to utilities.

Least preferred

Consumer discretionary: Higher mortgage rates tend to drive underperformance of the sector. The slowdown in housing could spill over into other discretionary segments. Consumer spending is shifting away from goods to services, and businesses are having a difficult time managing inventories. Retailers are seeing signs of trade-down as higher oil prices and inflation remain elevated. Investors should be aware that the market-cap-weighted version of the sector is highly concentrated, with Amazon and Tesla accounting for almost 50% of the total.
Materials
The performance of the US materials sector tends to be correlated with global economic growth. Decelerating economic growth and a rising US dollar both tend to drive relative underperformance.
For more, ask your financial advisor for a copy of the US Equity Sector Outlook Presentation, published in 23 September 2022.
Content produced by the Chief Investment Office.
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