Schwab Sector Views: When Growth Peaks

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There are signs that U.S. economic growth is slowing while interest rates are increasing, which has historically led to the shift to the left in S&P 500(r) Index sector dominance. Because of this and other factors, we’ll discuss in the following paragraphs, we’re boosting our rating for Financials in the direction of “outperforming” as well as Utilities downgraded to “neutral,” while downgrading Materials and Industrials to “underperform.” We’re keeping our outperform rating for this sector. Health Care sector as Ipass Loans reports.

Shifting to defend

With the rise of inflation rates, banks across the globe have begun to reduce the massive stimulus that fueled markets and the economy through the COVID-19 epidemic. It is expected that the Federal Reserve is widely expected to raise the rates of interest for short-term loans at its March meeting as well. Bank of England has hiked its policy rate two times already https://ipass.net/payday-loans-online-no-credit-checks/. In addition, it appears that the European Central Bank has indicated it’s thinking about tighter policy. We believe that tightening the economic environment could exacerbate the slowing in growth in the economy we’re seeing.

Some of the slowings that occurred as we approached 2022 could indeed be caused by the COVID-19 omicron variant’s rise, which is currently easing. In addition, household savings remain significantly higher than pre-crisis levels, but a lot of it could be concentrated in wealthy households who are less likely to use it. In the case of many other homes, these fiscal policy tailwinds that have been accumulating over the past two years will likely be a hindrance as federal spending slows down and measures like the increase in child tax credits and loan waivers end.

However, consumers’ confidence has dipped, and wage increases are being sucked up due to inflation. This includes rising rents due to the rise in house prices, which could add to the already declining consumer spending. We’re witnessing this slowing in the growth rate in several more reliable economic indicators, such as the ISM’s Purchasing Managers Indexes (PMI)–which provide an excellent overview of the current and possible future economic activity. 

The ISM Manufacturing PMI reflects the opinions of supply management experts regarding things such as new orders and prices paid, suppliers’ delivery times, and working conditions in sectors like computers, machinery, equipment, products, and well as transportation equipment. ISM Services PMI ISM Services PMI measures business activities in non-manufacturing sectors, including real estate, construction wholesale, retail trade, financial services, and utilities. As the graph below illustrates, the Manufacturing and Services PMIs have dipped from recent highs.

The growth in the economy has slowed. However, it remains positive

It’s also important to highlight that both indicators are over 50 index points, the line that separates growth from contraction in business–which is in line with a healthy and stable economy. According to various models of recession risk, the likelihood of recession is very low, such as those of the Federal Bank of Cleveland’s model for the recession, which is shown below. This is in line with PMIs staying at or above 50 for the moment.

Despite slower growth, the likelihood of recession is very low

However, it is true that when manufacturing PMI is at its highest–which again isn’t always a signal to recessions–there’s usually the tendency to shift from economically sensitive stocks to more defensive sectors that are more stable in their market. On the most fundamental level, it is logical–traditional defensive sectors provide items and services that people require even in times of slowing economic growth: Health Care, Utilities, and Consumer Staples, to name some. In the chart below, a mix of cyclical and defensive ones tended to follow that of the ISM manufacturing PMI lower in the wake of every peak in the period between the 2007 and 2008 crisis in the financial markets and the start of the COVID-19 epidemic.

Cyclical relative to defensive industries tend to shift with the manufacturing PMI

It’s evident from the chart below The most cyclical sectors –Financials, Energy, Industrials, Consumer Discretionary Materials, and Materials — tend to perform better in those sectors when the manufacturing PMI index is increasing. This is not surprising when you consider the impact that the economy’s strength usually has on industries boosted by growth in manufacturing and consumer consumption. 

However, the typically cautious sectors — utilities, Real Estate, Consumer Staples, Communication Services, and Health Care tend to perform better when the PMI decreases. These sectors have goods and services that can be used even in times of economic weakness or that typically have high dividends, which can be attractive in a time of slowing market growth.

Sensitivities of sectors differ concerning PMI as well as cyclical/defensive aspects.

Could it be different this time around?

The comparative performance of sectors during the years following an increase for the industrial PMI is consistent with these patterns; however, there are a few exceptions. It’s interesting that the overall S&P 500 index historically has been rising following these peaks and is in line with continued economic growth, though the market volatility tends to increase.

In terms of defensive sectors, all of them have been able to outperform overall markets generally. However, there were a lot of cyclical industries that have performed poorly, especially Materials, Energy, and Industrials. Financials stand out from what one might expect due to their cycle-driven nature and outperform the market 50 percent times. Most of these instances occurred close to Fed rate hikes when financials typically outperformed.

This demonstrates there was no evidence that these sectors were present in all the 10-years of PMI peaking since 1990 used to analyze this data. This leads to the question: could the pattern of relative performance be different this year? It is probably “yes.”

As we’ve mentioned many times in these pieces, and as most investors know, the current business cycle, driven mainly by the COVID-19 epidemic, has been unlike any other in the current era. For instance, the interest rates have followed an entirely different route from their usual relationship to industrial PMI. As you can see in the chart below, instead of moving near-lockstep with the PMI, the ten-year Treasury yield slowed in the recession and has been increasing in the meantime, while the PMI has been declining recently. In light of the Financials sector’s strong positive correlation with an interest rate, should the current trend persist, we believe it will — the recent Financials outperformance may last.

Our sector’s perspectives

In light of the connections discussed above, we’ve revised our outlook on Financials to be outperforming, in line with our expectation for continuing, albeit slowing economic growth and more interest rates despite rising inflation and Fed’s constant tightening of its monetary policy.

We’ve reduced our opinions regarding Materials and Industrials to underperform in large part due to our expectation that the cyclical trend of depleting the most volatile sectors will continue. We’re keeping our outperform rating for Health Care, a view that is bolstered by its solid long-term foundations, strong profit margins as well as attractive prices. More information on our thoughts on these and other industries in this article.

In addition, despite its record of sharply lower performance in this context, We’re keeping Energy at neutral given the significant risk to the oil market due to the increased uncertainty within Eastern Europe and the Middle East.

What does the word “rating” mean?

We examine sectors part of the well-known Global Industry Classification Standard (GICS(r)) groups. After reviewing the potential risks as well as opportunities, we award each sector of stock one of the following scores:

  • Outperform: likely to do better than the overall market*
  • Underperform: likely to do less than the overall market.
  • Neutral: There is no current consensus regarding the potential relative performance

What should I do with the Schwab Sector Views?

Investors should try to diversify their portfolios across all stock market sectors. It is possible to use the Standard and Poor’s 500(r) Index allocations to each industry in the above chart as a reference.

Investors looking to make strategic changes to their portfolios may use Schwab Sector Views’ outperform neutral, underperform, and outperform ratings to help. These ratings help review and monitor the national equity component in your investment portfolio.

Schwab Sector Views are also helpful in identifying stocks according to a sector that could be a good option for acquisition or sale. Customers can utilize this portfolio checkup tool to determine and manage sector allocations. Schwab customers may use the Stock Screener or Mutual Fund Screener to find the best prospects for buying or selling in specific sectors when it’s time to make changes. Schwab Equity Ratings is another valuable and fact-based tool for selecting and monitoring the performance of your companies.

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