Oil Prices Surge
The lack of movement in the Morningstar Global Markets Index last week masked divergent outcomes at the sector level, with energy stocks up 1% and healthcare stocks down more than 2%. The energy sector was buoyed by a 2.4% gain in crude oil prices as the conflict between Israel and Iran continued to escalate. The entry of the US into this fight over the weekend raised oil prices overnight and is likely to increase anxiety among investors.
Summer Brings Danger for Investors
While such conflicts can be resolved quickly, at least from a market perspective, the summer is a period when fewer market participants are at their desk and trading volumes are lower. This means that prices can be moved more easily, as demonstrated by the sharp decline and rebound at the start of August last year. These environments are ripe with potential investing mistakes due to the sense of peril and urgency they convey. However, it is important to remember that a lower stock price today does not mean that a company is worth less, merely that it is currently subject to negative sentiment. Successful investors focus on estimating the fair value of a business and comparing that to the current price. For companies covered by Morningstar analysts this is expressed through a star rating and the valuation charts.
While periods of crisis tend to push stock prices away from their fair value, it can also help close the gap, realizing the embedded value in a stock trading at a discount. This is most obvious in the energy sector where the median company was priced at a 14% discount to Morningstar’s estimate of fair value at the end of May. This gap has subsequently closed to 6.7%, delivering a 9.3% gain during June. Although this will be welcome news to those who own energy stocks in their portfolio, future gains are likely to be capped as the recent rise in oil prices is unlikely to impact the fair value of these businesses which are determined by an estimate of the medium to longer-term energy prices rather than the current price.
Healthcare Stocks Take a Political Hit
In contrast, the recent negative sentiment toward healthcare stocks was intensified by the dismissal of the entire Advisory Committee on Immunization Practices (ACIP) and their replacement by appointees seen to be closer to Health Secretary Kennedy’s skeptical perspective. Although vaccines comprise just 1% of healthcare company revenue, this latest move will be seen as compounding the political challenges faced by a sector where the median company is currently priced at an 11.7% discount to Morningstar’s estimate of fair value. This unusually wide discount creates a potentially attractive entry point for investors willing to look beyond the current political environment. Sarah Hansen, a senior reporter for Morningstar.com, unpacks these opportunities here.
The Morningstar Developed Markets ex-US Index fell 1.3% while the Morningstar Emerging Markets Index was flat last week due in part to a rise in the dollar. Despite relatively strong returns from international over the last six months, these markets remain attractively priced compared with the US. The opportunities conveyed by this pricing differential was explored in the latest Morningstar podcast, which can be accessed here.
Fed Worries About the US Economy
The Federal Reserve maintained interest rates at 4.25%-4.5% while revealing expectations among participants of lower economic growth, higher unemployment and inflation in 2025 expressed through the closely watched dot plots. In response, the committee nudged its assessment of appropriate interest rates slightly higher. The probability that interest rates will remain unchanged at the July meeting has increased despite the political pressure to lower rates. Morningstar’s Senior US Economist Preston Caldwell is expecting two interest rate cuts over the rest of the year. You can find out more here.
The first test of the FOMC’s dot plots will come on Friday with the release of the committee’s preferred measure of inflation, the Personal Consumption Expenditures Prices Index. Core PCE is expected have risen by 2.6% on an annual basis in May, a little higher than last month’s reading of 2.5%.
Earnings Season is Coming Again
Looking further ahead, the end of the quarter brings the onset of a new earnings season which is, as ever, preceded by lowering profit expectations in the hope of generating a nice ‘surprise’ for investors when the results are announced. According to FactSet, analysts are currently expecting 12-month earnings growth of 4.9% for the second quarter, well below the estimate of 9.3% set at the start of the quarter.
While economic conditions have clearly changed over the last three months, analysts are currently giving themselves plenty of room to be ‘surprised’ even if the near-term outlook for companies has deteriorated. This illustrates the importance of investors looking a little further ahead especially when markets are volatile.
