Earnings will be strong this year supported by secular economic trends, says Citi's Drew Pettit

Key Concepts

• Secular Trends: Long-term shifts in the economy that persist regardless of short-term cyclical fluctuations.
• Supply Choke Points: Specific areas in the supply chain (e.g., semiconductors) where demand significantly outstrips supply, creating pricing power.
• Hyperscalers: Large-scale cloud computing providers (e.g., Amazon, Google, Microsoft) with significant cash reserves and strong balance sheets.
• Pricing Power: The ability of a company to pass increased input costs to customers without losing significant demand.
• Cyclical vs. Growth: The distinction between companies sensitive to economic booms/busts (cyclical) and those driven by structural, long-term expansion (growth).

Market Outlook and Fundamentals

Drew Pettit, U.S. Equity Strategist at Citi, suggests that the market is currently looking past the "messiness" of Washington politics and Federal Reserve interest rate uncertainty. The focus has shifted back to fundamentals.

• Earnings Expectations: Citi anticipates a strong year for earnings, driven primarily by secular economic trends rather than cyclical recovery.
• Market Sentiment: Despite some weakness in cyclical sectors, the broader market is showing resilience by looking toward long-term growth drivers.

The Semiconductor and AI Infrastructure Thesis

Pettit emphasizes that the semiconductor story is not a traditional cyclical narrative but a growth story.

• Supply Constraints: Semiconductors are identified as the primary "choke point" for the AI build-out. Markets are rotating toward these supply-constrained areas where margins are expanding and sales growth is outpacing asset growth.
• Decoupling from Cyclicality: Unlike traditional cyclical sectors, the AI/Semiconductor space is insulated because its primary buyers—hyperscalers—possess robust balance sheets and significant cash reserves. This allows them to absorb costs, whereas consumer-facing companies struggle to pass inflation-related price hikes to their customers.

The Economic Transmission Mechanism

A key point of discussion is whether AI investment will eventually benefit the broader economy through wages and consumer spending.

• Earnings First: Pettit argues that the economic benefits of AI investment accrue to corporations first. While there is wage inflation in specific technical job sectors, the transition to the broader consumer economy is not "one-for-one."
• Labor Market Nuance: Citi’s economists note that the current labor market is not providing a "clean read" for broad economic health, suggesting that the wealth effect from AI investment is currently concentrated in corporate earnings rather than widespread consumer prosperity.

Defense Sector and Industrial Strategy

Pettit highlights a divergence in the industrial sector, specifically regarding the defense industry, which has faced recent downward pressure.

• Buyer Power: In the defense sector, the buyer (the government) holds significant power. Consequently, defense companies struggle to pass on increased input costs, which compresses margins.
• Investment Criteria: Citi’s strategy for the industrial sector focuses on identifying companies that possess pricing power—the ability to maintain margins by passing costs to buyers. This is the primary filter used to distinguish between attractive industrial opportunities and those facing margin pressure.

Notable Mentions

• Preferred Stocks: Pettit explicitly mentions a preference for NVIDIA, Micron, Teradyne, Rockwell, Eaton, CrowdStrike, Palantir, Eli Lilly, and Boston Scientific.
• Strategic Rationale: These companies are favored either due to their role in the AI infrastructure build-out or their ability to maintain margins in a challenging inflationary environment.

Synthesis

The core takeaway is that the current market environment favors companies with structural growth narratives and strong pricing power. The AI build-out is viewed as a secular trend that is currently insulated from broader economic cycles because its primary participants (hyperscalers) are financially resilient. Investors are advised to avoid sectors where buyers hold the leverage—such as defense—and instead focus on supply-constrained areas where companies can effectively manage margins despite input cost volatility.