Conversations From The Road, Part 2 - Transcript

Welcome to RBC’s Markets in Motion recorded June 30th, 2022. I’m Lori Calvasina, head of US equity strategy at RBC Capital Markets. Please listen to this podcast for important disclaimers. Today in the podcast, our thoughts on a few additional questions that we’ve been getting from equity investors in our recent travels across the US, a topic we also explored in our last podcast.

Three big (new) things you need to know: First, equity investors have been asking us whether inflation has been good for stocks and earnings. We think that it has, and view moderating inflation as more of a headwind in the outlook for stocks than many investors may realize. Second, a number have asked our opinion on the low quality trade. We’ve reminded investors that low quality tends to outperform after the stock market has found its mid-recession bottom. We’d expect the same this time around for a short period of time. Third, a number have asked if we could dig deeper on our sector recession playbook analysis, and we’ve replicated it for the 24 industry groups. Areas that tend to outperform during recessions as well as the broader market drawdown and rebound phases include Commercial & Professional Services, Consumer Services, Materials, Retailing, and Transportation. 

If you’d like to hear more, here’s another five minutes. While you’re waiting, a quick reminder that you can subscribe to this podcast on Apple, Spotify, and other major podcast providers. Now, let’s jump into the details.

Takeaway #1: We Think Inflation Has Been More Good Than Bad For Stocks

The question of whether inflation has been good or bad for stocks, particularly earnings, is the most interesting question we’ve gotten recently. Our take: we do think inflation has been good for equities and see the potential for inflation to moderate from here as a headwind that should be factored into equity outlooks.

In terms of earnings, we see two clear ways that inflation has been good for stocks. First, S&P 500 revenues have been highly correlated with trends in CPI over time, with a correlation that’s been a tiny bit higher than what we seen for GDP.

Second, we’ve generally found that inflation based indicators like copper have been positively correlated with trends in margins. Have higher commodities and input costs been a pressure on margins? Absolutely. But what our back testing and modeling tells us matters more is the health of the economic cycle and strong commodities and inflation have generally reflected that strength.

In this conversation, we’ve also pointed out that over time there has been a close relationship between the rate of inflation and equity ownership trends by US households. When inflation has ramped, equity ownership has increased.

Even though moderating inflation should admittedly provide some relief to P/E compression, we think that a moderation of inflation could pose more of a problem for US equities in 2023 than many investors realize if that trend does indeed materialize.

Moving on to Takeaway #2: We’d Expect Low Quality To Work Well After A Bottom In Stocks Is Established For a Short Period of Time

Most of the investors we’ve been speaking with have cleaned up their portfolios, trimmed positions, and have become more concentrated in higher quality names, leaving many feeling like they are in a good position to weather whatever storm is coming. In this context, the big risk to their portfolios is not if the stock market keeps falling, but if a bottom is established and a rebound takes hold. In this context, they’ve been asking us about the fate of low quality stocks.

We think this question is coming up because low quality perked up in June on a variety of factors, most noticeably within the Russell 2000, last month after a fairly long stretch of high quality leadership.

 We’ve reminded investors that low quality stocks tend to outperform coming out of recessions after the stock market finds its mid-recession bottom and we don’t think things will be any different this time around. But we also think a low quality bounce in the market coming off the bottom may be more short-lived than usual, as we expect the economic backdrop to be somewhat sluggish in a recovery from the (possible) upcoming recession and rife with uncertainty given a lack of stimulus from the Fed and DC. 

Wrapping up with takeaway #3: The Historical Recession Playbook For The 24 Industry Groups

We’ve spent a lot time over the past few weeks highlighting our work showing how different sectors within the S&P 500 and S&P 600 tend to perform, relative to the broader market, during recessions and in market drawdown and rebound phases. A number of investors have asked us to dig deeper and take a look at the takeaways by industry. Methodology changes over the years make that a challenging exercise for GICS level 3 industries, but we were able to replicate our analysis for the 24 GICS level 2 industry groups using the S&P 1500 universe, which is reflective of both Large Cap and higher quality Small Caps.

Two things caught our eye. First, areas that tend to outperform during recessions as well as the broader market drawdown and rebound phases include Commercial & Professional Services, Consumer Services, Materials, Retailing, and Transportation. 

Second, Autos & Components, Banks, Cap Goods, Diversified Financials, Insurance, Media & Entertainment, Real Estate, Semis & Semi Equipment, Software & Services, and Tech Hardware & Equipment tend to underperform in the broader stock market drawdown phases but outperform in the rebound phases.

History is unlikely to repeat exactly this time around, but is a useful place to start when thinking about next moves.

That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s Industries in Motion, for additional thoughts on specific sectors from RBC’s team of equity analysts.