Dissipating Headwinds in the Market

Morningstar’s chief U.S. market strategist David Sekera discusses several headwinds at the start of 2022 and where he sees the market today and in the next few quarters.

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Summary – IBKR Podcasts Ep. 32

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome everybody to today’s IBKR podcast. I’m delighted to be here with Morningstar’s chief U.S. market strategist David Sekera. How are you, David?

David Sekera

I’m doing well.

Andrew Wilkinson

Thank you for joining me today and we’re going to go straight into today’s discussion. David, in reviewing your earlier work … Morningstar, talked about several headwinds at the start of 2022. Could you define for the audience those headwinds and where you see things today?

David Sekera

Of course, well, as you mentioned Andrew, in our 2022 outlook we did note that coming into the year, based on our calculations, we viewed the market as overvalued, and noted that there were four main headwinds that the market was going to have to contend with this year. So, first was just the slowing rate of economic growth that our US economics team was projecting. The Federal Reserve … to tighten monetary policy and of course inflation was already running hot even at that point in time, and we also expected the interest rates would be rising over the course of the year.

So, I think what we’ve seen here in the first half of the year is these headwinds as a combination have all certainly taken their toll on the markets. However, at this point based on a couple of different indicators we’re watching in our forecasts, we think that these headwinds are actually now starting to begin to dissipate. So, between the market pullback that we’ve had already thus far this year … that these headwinds are now starting to dissipate. Yeah, we actually think the broad market is undervalued today.

Andrew Wilkinson

OK, so let’s turn to the outlook for growth. Given 2 back-to-back quarters of consecutive negative readings, what’s Morningstar’s expectation for GDP going forward?

David Sekera

So right now, our current estimate for 2022 real GDP growth in the US is 2%. And as you mentioned, following two quarters of negative GDP growth … what that really means for the second half of the year is that in order to achieve that growth rate for the full year … Now that means the economy is going to have to average about a 3% annualized rate for the second half of the year.

So, thinking about the next couple of quarters, we do expect that many of those bottlenecks and some of the other supply shocks that we had at the first half of the year, those have been plaguing the economy. Those are in our view, are starting to be resolved and then looking at some of the other details in the GDP reports … The negative impact from net exports and inventories, we believe those will abate over the next couple of quarters as well. And then finally, it also notes that in our forecast we do project the consumption and investment should both continue to expand over the second half of the year.

Andrew Wilkinson

OK, well let’s look at inflation and interest rates. What’s the outlook for monetary policy? Where is the Federal Reserve on its inflation fighting journey, David?

David Sekera

Well, I do have to admit, inflation has run even hotter thus far this year than what we had originally expected and right now our current forecast for inflation for the full year is 5.8%.  So, I would note that our head of US economics … He had opined that he thinks inflation actually peaked in June and that it will begin to moderate over the next few months. And in fact, I think looking at this most recent CPI report for July that came out this morning … yeah, that appears to support his analysis.

Now looking forward for investors, his inflation forecast for 2023 is down to 2% and he believes that there’s a number of different deflationary forces that will take hold in the latter part of 2023. So, when I look at some of the main assumptions that support his forecast is that while inflation is high, we expect the unwinding of several different price spikes that have been caused by those supply constraints, and think about areas that we’ve seen, such as durables and energy. As those price spikes are to moderate and come down, that will certainly help bring the overall level of inflation down as well.

The other thing that he’s pointed out is that much of the inflation we’ve seen has been contained in only a couple of different categories such as energy and the price of new automobiles. And so, when we’re thinking about inflation going forward, we do note that inflation in both of those specific areas has been easing. Oil prices had hit their highs, looks like they’re starting to come down, so those prices have subsided and the semiconductor shortage which had caused some of the price spikes in automobiles, that shortage is easing as well.

Andrew Wilkinson

OK, so let’s bring that together as we look at the stock market and we look at valuation specifically. Where does all this leave the equity market now?

David Sekera

Well, first I would note is I think we take a little bit of a different approach than many other research firms and what I mean by that is our market valuation is built on a purely bottoms up basis. So, when I calculate our market valuation … That’s based on a composite of about 700 stocks which is covered by our equity research group that trade on US exchanges. So, we use those fair values as determined by the analysts and we’ll calculate the fair value of the market based on that and compare it to where the market is actually trading. So, for example, as of August 5th, the broad market was trading at 11% discount to those fair values. Now we are seeing a surge in the markets this morning, following that encouraging inflation data so that discount would be slightly lower now, but even so, we still think that the market overall does have additional upside to reach our fair value.

Andrew Wilkinson

And so, how do you break down valuation by category for example?

David Sekera

Sure, so we break down the broad market valuation several different ways. The first is using the Morningstar style box, and so that breaks down the stocks into several different categories. So, your value, your core, also known as blend stocks and then growth stocks and then we also break it down by large, mid and small. So, the overall market as of last Friday, August 5th was trading at 11% discount overall, but looking at some of the different categories like the value category was trading at a slightly greater discount that was at a 15% discount and the growth category was also trading at a 13% discount. So, both of those in my view look relatively attractive, whereas like the core category was only trading at a 4% discount, so again much closer to fair value. And then even looking at by market cap we saw that the discount for large cap and midcaps were relatively similar at 10% and 11% respectively but saw the best value for investors in that small cap category … that was trading at a 27% discount to our fair value.

Andrew Wilkinson

And how about by classification?

David Sekera

Sure, so we do also breakdown our valuations by the 11 major sector classifications and when I look at those, I would note that the communications sector right now in our view, that’s the most undervalued trading at a 32% discount to our fair value as of last Friday.  Now, I would note in the communication services sector, that is going to be skewed. So, when you look at that sector, Alphabet, the parent of Google and Meta, the parent of Facebook … Those two companies because they’re large, their market cap is so large, they represent over half of that sector’s market cap, and we think both of those stocks are undervalued today. Now, having said that, even in some of the more traditional areas and communications and media, I’d note that we do think there’s a lot of other stocks within there that are undervalued as well.

Taking a look at some of the other sectors, we look at the cyclical sectors and of course some of those have been the hardest hit by this year’s sell off. We think that there’s a number of different opportunities in those cyclical sectors. So, looking at those basic materials, consumer cyclical, and financials …  those would be other areas that we point to today for investors to take a look at.

And then within those individual sectors, I always tried looking for secular themes that I think are interesting in today’s marketplace. So, for example, one of those themes I would note is that I think we have an above consensus view on the growth of electric vehicles. So, we actually project that by 2030, two-thirds of all new vehicles will be electrified, meaning either a battery electric vehicle or hybrid vehicle.

So, one of the ways to be able to invest in that long term secular growth trend is not necessarily just in the automakers, but also in the suppliers. So, thinking about like the basic materials sector, we think that lithium will be under supplied over the next decade and we think there’s a lot of opportunities for investors in that specific area. So, for example, with lithium last year in 2021, I think it’s less than half a million tons of lithium were actually used, but we expect that by 2030 that demand will increase to 3.3 million tons. But right now, looking at the amount of producers out there and what their forecasts are for how much they can you’ll produce by then … We forecast there’s only going to be 2.3 million tons available, so that should keep lithium prices high for the next several years before it starts coming back down to the marginal cost.

Other ways that we look at to invest in that electric vehicle growth theme would be in the specialty chemical companies. It actually takes several times more specialty chemicals to produce an EV than the internal combustion engine, and so those specialty chemical providers with the product portfolio geared for those EVs … We think those should do very well as well.

So then turning you out to the flip side of the coin, you know, looking at some of those defensive sectors, they certainly did their job and they held up relatively better during this downturn, but we think that most of the defensive sectors are actually kind of fully valued, to overvalued here. And the one that I would caution investors today would be the utility sector. So, in our view, we think that sector is about 10% overvalued, and I’d also say that if we’re wrong about inflation and inflation were to continue to run hotter for longer … That would be one of the sectors that I would think would be most at risk to the downside. So essentially, utilities … They don’t really have pricing power because they have to get approval from the regulators in order to raise rates and so depending on the regulatory environment, that could take anywhere from months to over a year to be able to put those cost increases through to their own clients.

Andrew Wilkinson

There’s a term I picked out that you use, “the normalization of consumer behavior.” You’ve written about that recently. Can you describe what that is and what the implications might be?

David Sekera

Of course, so when you think about back at the beginning of the pandemic, all spending came crashing down, but I would notice that spending on goods not only quickly recovered, but actually it skyrocketed higher and higher than what kind of the pre pandemic trend had been where spending shifted out of services and has really lagged that recovery. And when I think about spending, a lot of those categories that really did well, maybe in like some of the electronics categories … Anything to do with supporting kind of that work at home environment, home entertainment, or home remodeling and redecorating as people were stuck at home, that’s really where that spending had shifted to. And of course, services lagged just because consumers at that point in time were either unable or unwilling to go out in public.

So now, as the pandemic continues to recede, we’re seeing and expect to continue even more that the spending in services category should continue to continue increasing as a percent of all spending, coming out of those goods categories. So, in order to return to what would have been your pre-pandemic trends, our economics team is looking for about a $450 billion shift of spending out of goods and back into services. So, what we’ve been looking for are different ways to be able to invest in that, and so we’re looking for underlying subsectors that should benefit from that shift in spending. So, for example in the travel industry, a lot of leisure travel has already recovered, but business travel has certainly lagged far behind, and I know our consumer analyst team is forecasting that business travel should return to pre pandemic levels by 2024. So, I think that provides some opportunities there.

And so, then we look for undervalued opportunities within some of the different sectors. So like areas that I always recommend investors to take a look at it would be like airlines, travel technology, cruise lines, gaming, hotels, those type of areas. Then I’d also say we could look at what I call like some of the second derivative investment opportunities out there where it’s not necessarily that shift itself that will cause some of these stocks to do better, but kind of that second derivative where they’ll see better operating margins because you have that shift if that makes sense.

So, for example, like one example I like to use is in alcohol consumption. So, the amount of alcohol consumption really didn’t decrease during the pandemic, but it shifted from on premise to at home, and what our analyst noted is that consumers will purchase lower tier brands, which of course then have lower margins, when they consume at home, as opposed to being more brand conscious when they consume in public. So as that consumption then shifts back to public, they go back to those higher tier, higher margin brands. We think that will help generate higher margins for those alcoholic beverage companies.

Andrew Wilkinson

David Sekera is the Chief U.S. market strategist with morningstar.com. You can read more from David, you can see his commentary at morningstar.com. Thank you so much for joining us today, David. That’s a fantastic insight into the US economy and market. You can hear more from us at ibkrpodcasts.com. Thank you very much, David.

David Sekera

Oh, thank you. I appreciate your time.