In a Strong Economy, Banks Not Beverages

03.23.2017 - Carin L. Pai, CFA

Given our macroeconomic views as we began 2017, one of the most noticeable changes in our thinking about market sectors is a more favorable outlook for Financials and less enthusiasm for the Consumer segment. This posture reflects an economy in transition.

Policies Favor Financials

We see a number of potential tailwinds for Financials, including tax reform and deregulation. For example, President Trump has started to chip away at regulations like Dodd-Frank, which have hindered competitiveness and increased costs and are especially tough on smaller, regional banks.

Financials is one of the few sectors that stands to benefit from rising long-term interest rates. Banks should earn higher yields on the long-term loans they make to customers while paying relatively low rates on their own short-term debt. Rising rates could also be a net positive for insurers and other asset-sensitive institutions, boosting yields on their investment portfolios.

As the economy improves, lenders could see a pickup in loan and mortgage applications. Although mortgage rates have been rising slowly since 2012, we believe they are likely to remain low enough to encourage borrowing for quite some time. A healthier economy, rising rates and the prospects of deregulation have also lifted the asset management industry. Valuations for Financial stocks were boosted by the US elections, but still appear reasonable with room for earnings improvement.

Retailers Face Challenges

At first glance, it might seem logical that an improving economy and tax reform would be overwhelmingly positive for the Consumer sector. But it is important to remember that President Trump wants his tax cuts to be “revenue neutral.” So lawmakers will be looking for new sources of government revenue to offset any reduction in taxes.

This could be a good news, bad news situation for the sector. For example, the so-called Border Adjustment Tax would essentially provide US companies with a subsidy on the goods they ship overseas. But it would also impose a tariff on imports, including the equipment and materials they use in manufacturing. The apparel and auto industries have the broadest exposure to taxes on imported materials, as net imports account for over 30% and 20% of their domestic supply, respectively.

Consumer spending remains healthy in aggregate, but has been losing momentum as food and energy prices rise and essentials such as healthcare and education take a greater share of wallet due to rising inflation. In this environment, we are especially cautious about investing in traditional retailers and apparel manufacturers—areas where e-commerce is putting long-term pressure on prices and operating margins.

Finally, from a valuation standpoint, consumer companies associated with food and beverages, personal care products and tobacco appear to be on the more expensive side, as investors have awarded these companies a premium for their defensive qualities or the perceived stability of their earnings. However, their growth potential outside of restructuring opportunities looks weak to us.

Sectors versus Securities
To be clear, these are broad statements about two distinct market sectors that appear to be in transition. While we expect certain tailwinds to lift Financials and headwinds to restrain Consumer segments, there are specific industries and companies within each sector that we find more attractive than others.

As fundamental investors, our primary focus is on finding companies with strong balance sheets, reasonable valuations, long-term growth potential and the ability to weather all economic cycles.

This communication is intended solely to provide general information. The information and opinions stated are as of March 24, 2017, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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