Playing defence through quality and pricing power

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Refinitiv Datastream unless otherwise stated, and are accurate at the time of publishing.

Key points

• Waning economic momentums, rich equity market valuations and simmering geopolitical tensions threaten another volatile year for investors
• With business activity and inflation trending lower, expect more dispersion in equity market performance, with a renewed focus on corporate profitability, financial leverage and balance sheet strength more generally
• In this environment, quality companies, with recurring revenues and strong pricing power, are likely to be better equipped to weather economic storms and sustain revenues and profit margins
• Our analysis reveals that sectors like consumer staples, healthcare and tech generally enjoy superior pricing power. Conversely, commodity sectors like energy and basic resources, and to a lesser extent media, chemicals and autos, typically face greater pricing constraints

Global equities rallied by 16% between their October lows and December highs, since when they have been range-bound. Investor sentiment has become extremely bullish, while positioning is now extended by historical standards. This leaves the market vulnerable to disappointment in the near term. 

Rally driven by hopes of rate cuts and a soft landing

The recent rally has been driven by increased confidence among investors that a global recession could be avoided, and that central banks will cut rates in 2024. 

Under the surface, equity investors have oscillated between periods of optimism and pessimism, based on incoming economic data and central bank communications. In turn, they have recalibrated their expectations of a hard versus soft landing, as well as the timing and magnitude of anticipated rate cuts. The changing outlook has sparked rotations between cyclical and defensive sectors, value versus growth stocks, and small-cap companies against large-cap companies.

In the coming months, equity markets are likely to remain driven by inflation prospects and central bank communications, as well as geopolitical risk and upcoming elections in a number of key regions. Investors are also likely to become more discriminating as economic activity continues to slow, with a renewed focus on corporate profitability, financial leverage and balance sheet strength more generally. 

Strong bounce in company profits expected by analysts this year

Despite significant earnings downgrades in recent weeks, in reaction to lowered corporate guidance, equity analysts still expect a strong rebound in corporate profits globally this year. They anticipate a 10% rise in global earnings in 2024 (versus 8% reported on average in the past 20 years), driven by a combination of revenue growth and margin expansion. 

Potential risks around that view

With inflation trending lower and consumer demand decelerating, revenues are likely to come under pressure globally, both from a price and a volume standpoint. In recent months, the economy has been supported by strong consumer spending and a tight labour market. However, the large excess savings accumulated during the pandemic will soon be depleted, and we are starting to see cracks in the labour market.

Operating margins are also likely to weaken from near-peak levels globally, as competitive pressures build.

Quality and pricing power as a protection

In that context, investors would do well to focus on quality companies, with recurring sources of revenues and strong pricing power, which are better positioned to sustain revenues and margins in periods of economic slowdown. Balance sheet strength is another important attribute, especially if rates remain higher than the market expects, for an extended period of time. Highly leveraged companies with low interest coverage ratios could face refinancing risk, when the debts accumulated in times of low rates come to maturity.

Pricing power is a key characteristic of quality companies, but it is hard to quantify, as its drivers vary between industries, and even from company to company within the same sector. Pricing power is generally associated with strong brands, market dominance, product differentiation, cost leadership and high barriers to entry. To maintain pricing power over time, companies also need to be innovative and consistently reinvest in their business, to respond to changes in the competitive and regulatory landscape, as well as shifts in consumer preferences. 

Ranking sectors according to their pricing power

While pricing power is best assessed at the company level, gauging how sectors fare against each other on that metric can also be useful when making investment decisions. 

In the chart below, global equity sectors are ranked according to the stability of their operating margins, which we use as a crude proxy of pricing power. The chart measures the coefficient of variation of the sectors’ earnings before interest and taxes (EBIT) margins over the past ten years.  Financial companies are excluded from the analysis, as EBIT margins are less relevant for that sector. 

While the approach is imperfect and incomplete, it is based on objective criteria and allows sectors to be assessed on a comparable basis. The results make intuitive sense:

• Sectors like consumer staples, healthcare and technology generally enjoy stronger pricing power.
• At the other end of the spectrum, commodity sectors, such as energy and basic resources, and to a lower extent media, chemicals and autos tend to have more limited pricing power in aggregate.  
• The telecoms sector is an outlier in this analysis. While enjoying relatively high and stable margins over time, thanks to cost cutting and automation, the sector has very limited pricing power due to the increasingly commoditised nature of its services

Global sectors' margin stability, based on earnings before interest and taxes (EBIT)

Coefficient of variation of global sectors’ EBIT margins over the past ten years

Those findings are consistent with the sectors’ relative performance under different inflation scenarios. As illustrated below, the best performing sectors in times of declining inflation tend to be the ones with strong pricing power: healthcare, consumer staples and utilities.

If inflation were to overshoot on the upside as a result of stronger economic growth, cyclical sectors such as autos, chemicals and basic resources would likely outperform the more defensive parts of the market, at least temporarily.

Correlation of global sectors' relative performance versus US inflation break-even yield

Correlation of global sectors' performance relative to the broad market unless otherwise stated (*) versus US inflation break-even yield, based on six-month price changes over the past ten years

Investment implications

Given the weak macro backdrop, combined with rich equity market valuations, extended sentiment and heavy positioning, a defensive portfolio positioning appears warranted in the near term. 

Defensive sectors and ‘bond proxies’ tend to outperform the rest of the market in periods of economic slowdown, declining yields and shrinking inflation, while retaining superior pricing power. Among those, consumer staples and utilities appear particularly well positioned, based on cheap valuations and conservative earnings forecasts. 

Given the high level of uncertainty in markets at present, a balanced positioning also seems prudent, with select exposure to the more cyclical parts of the market that trade at a deep discount to their historical average, such as energy stocks. 

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