Searching for Conviction

The breakout of conflict in Israel has stalled the rapid ascent of U.S. Treasury yields. Despite difficult supply and demand dynamics, Treasury bonds remain a haven in times of stress. The 10-year Treasury yield fell just 18 basis points, but the momentum change was enough to take pressure off stock markets. In addition, September’s consumer price report was consistent with the deceleration in core inflation and Fed officials are building a case to hold rates steady through the remainder of the year. Against this backdrop, stocks have managed to find some footing as we enter the third quarter earnings season.

The tragic events of the past week offer a stark reminder of the state of geopolitical stability. Tensions are rising and adversaries are showing a greater willingness to act out and exploit their enemies’ vulnerabilities. Markets have taken notice. Despite a slow start to the year, Energy and Defense stocks are right back at the forefront of leadership. The Israeli/Hamas conflict is unlikely to meaningfully alter crude supplies or defense spending, but it is another destabilizing force in a period of fragile international relationships. We believe it is important to hedge against adverse geopolitical events. At minimum, crude prices look to have a solid floor in place with a higher potential for upside shocks, while Defense spending is likely to be prioritized in a world with two major ongoing conflicts. Energy and Defense are two of our highest conviction sectors.

Outside of Energy and Defense, we continue to place a premium on highly visible earnings growth. Though momentarily stalled, we still believe in higher interest rates for longer. In that world, the band of attractive stocks narrows. As we move into earnings season, we hope to get a clearer picture of the companies separating themselves from the pack with organic earnings growth.

It is also equally important to avoid exposure to trouble spots. Companies with heavy debt loads or those needing frequent access to the capital markets remain vulnerable in the current high interest rate environment. We have seen this most recently in the performance of Utilities and REITs. In addition, we are paying special attention to steer clear of companies we consider “price takers.” While inflation is winding down, it is not yet beaten. Companies without pricing power are difficult to get behind.

We also have an eye toward what we call “big dumb trends,” the most obvious of which is the evolution of Artificial Intelligence. AI has the potential to unlock productivity over the next decade and the long-term benefactors are already emerging. Another revolutionary trend that has caught markets by surprise is the introduction of GLP-1 weight loss drugs, such as Ozempic and Wegovy. These drugs have posted wildly successful results in weight loss and overall wellness. Rapid deployment of these drugs could have a long-term impact on everything from health insurance to packaged food companies.

While higher interest rates have certainly been a headwind, we believe it is still possible to find conviction in stocks. The landscape looks much different than what many investors are used to, but there are companies we know will thrive. We continue to seek out these stories.

Thanks,
Preston May, CBE®
Research Analyst