A slowdown could be on the horizon, and analysts are predicting more earnings downgrades. Throw in a possible peak in inflation, and that mix of factors could favor a certain category of stocks. Skyrocketing inflation has underpinned the U.S. Federal Reserve’s hawkish tilt, said Jefferies in a July 29 research report. But a recent decline in commodity prices is bringing relief to the market on expectations of a peak in U.S. consumer prices, the bank said. Jefferies says a peak in inflation will favor one class of stocks: quality shares. Quality companies are those with stable performance — strong balance sheets, modest debt and resilient profitability. “Our study of past periods of falling US inflation expectations suggests that it is time to focus on quality stocks, which have derated on a relative [price-to-earnings] basis,” Jefferies analysts wrote. In addition, a “style shift is underway” after more than 18 months of a cycle that favored value stocks, according to Jefferies. Value stocks had been a significant beneficiary of rising inflation, and it’s time to move away from them, it added. Such stocks are said to be trading at discounted levels relative to their fundamentals, such as earnings. “With rate rises still set to slow economic growth, and shrinking PE dispersions, quality stocks will be back in favour,” Jefferies added. In July, markets saw the first round of earnings downgrades, led by the United States and Asia. Most major sectors are now facing cuts in consumer services, utilities and tech hardware, Jefferies said. “After performing strongly for over 18 months, we believe that value will take a backseat amid slowing earnings and a challenging macro environment. Globally, we now prefer quality stocks as recessionary risks take hold,” the bank said. It upgraded health care and consumer sectors to overweight. Stock screens Jefferies produced a screen of quality stocks that investors can buy, based on a list of metrics which include: High profitability — next two-year return-on-equity and return on invested capital at greater than 10% Reasonable valuations — 12-month forward price-to-earnings ratio less than 25 times Good cashflows — companies with positive free cash flow conversion Growth and revision — “relatively better” FY 2022-2023 EPS CAGR (compound annual growth rate of earnings per share), and earnings revision over the past three months. The screen turned up Apple , Visa , chipmaker Broadcom , retailers Home Depot and Dollar General . Among global stocks, there were pharmaceutical firm Roche, automaker Volvo , IT firm Fujitsu and chipmaker TSMC .
