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Navigating the US stock market at a time of recession

All signs are pointing to a recession in the US in the second half of 2023, with the impact of higher interest rates starting to be felt in the real economy. But, says Lisa Yang, manager on the BlackRock Sustainable American Income trust, there are always companies that can thrive.

Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.

If the Federal Reserve has got its sums right, the US economy is about to lurch lower. The US central bank has made it clear that its priority is to tackle rising prices, and the US economy will have to take the pain. While inflation levels are dropping, rate cuts seem a distant prospect and the economy is starting to teeter.

The BlackRock Investment Institute has been suggesting that this trade-off would be necessary. There has been too much optimism, from both investors and the Federal Reserve, that growth could be sustained even as interest rates ticked higher. The economy may have made a stronger start to the year, but is likely to stall later in 2023.

Stock market valuations

There is a question mark over the extent to which stock market valuations reflect this potential weakness. To date, corporate earnings have been relatively buoyant. Companies have managed to sustain their profit margins and pass on higher input costs to their end customers[1]. High employment levels have allowed companies to flex their pricing muscles, with little deterioration in volumes.

This has supported stock market valuations in the short-term, but for some companies, this pricing power may fade as the recession bites. The savings pot accumulated by many households during the pandemic has largely been spent[2], and consumers will have to rein in their spending as higher interest rates and inflation eat into their disposable income. As a whole, the US stock market is not reflecting this potential weakness.

Our solution on the BlackRock Sustainable American Income Trust has been to stick firmly to quality companies; those companies with strong balance sheets, that don’t need to borrow to thrive and can weather the economic bad weather. These companies have their destiny in their own hands.

The importance of quality

Quality companies tend to have resilient pricing power, that should endure even as the US economy slows. Poorer quality companies may have managed to stretch their profit margins in the short-term, but there are clear signs that volumes are declining as a result. This is unsustainable, and companies may experience diseconomies of scale as a result.

We also need to pay close attention to valuations in this environment. Technology has been one of the largest sector weightings in the portfolio, but can be subject to periods of over-valuation. At the moment, just 15% of the portfolio is in technology and it is focused on high quality, well-established businesses, such as Microsoft, Cognizant and Cisco.

Healthcare is the largest weighting. Here, we find more genuinely defensive companies than in, for example, the consumer staples sector. No-one stops using healthcare because there is a recession. Valuations are more attractive. There are some areas, such as medical devices, where volumes are depressed because of Covid, which delayed routine operations. These operations are now coming back, but stock market valuations don’t yet reflect this revival. This is another hunting ground for the trust.

There are also areas that require caution: industrials, for example, used to be considered a cyclical sector, sensitive to the economic climate. However, the sector is currently trading at a premium to the (also expensive) consumer staples sector. The supply chain disruption around Covid created unusual patterns of demand, with customers double-ordering to ensure supply. The market appears to be extrapolating this demand out into the longer-term, but supply chain problems are now resolving.

We also see weakness in the real estate sector, which appears uniquely vulnerable to higher interest rates. A lot of projects started during Covid in a lower interest rate environment. These will come online into a weak demand environment and put pressure on the wider sector.

It has become fashionable to say that the US stock market is over-valued and doesn’t fully reflect the impending weakness in the US economy. There is some truth to this, but the US stock market has considerable breadth and variety. It is always possible to find great companies that can deliver strong growth through the economic cycle. Focusing on these businesses is likely to be more important than ever as the environment weakens in the second half of 2023.

For more information on this Trust and how to access the potential opportunities presented by North American markets, please visit www.blackrock.com/uk/brsa

Trust specific risks 

This information should not be relied upon as research, investment advice, or a recommendation regarding any products, strategies, or any security in particular. This is for illustrative and informational purposes and is subject to change. It has not been approved by any regulatory authority or securities regulator.

The environmental, social and governance (“ESG”) considerations discussed herein may affect an investment team’s decision to invest in certain companies or industries from time to time. Results may differ from portfolios that do not apply similar ESG considerations to their investment process.

Exchange rate risk: The return of your investment may increase or decrease as a result of currency fluctuations.

Risk to capital through derivative use: The fund may use derivatives to aim to generate more income. This may reduce the potential for capital growth.

Capital Growth/Income variation risk: Investors in this Fund should understand that capital growth is not a priority and values may fluctuate and the level of income may vary from time to time and is not guaranteed.

Derivative risk: The Fund uses derivatives as part of its investment strategy. Compared to a fund which only invests in traditional instruments such as stocks and bonds, derivatives are potentially subject to a higher level of risk.

Gearing risk: Investment strategies, such as borrowing, used by the Trust can result in even larger losses suffered when the value of the underlying investments fall.

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