Insights


Which Sector to Battle Inflation? Try Materials

For many investors, inflation overtook COVID as the largest threat to markets back in March. While the transitory nature of some of the pricing pressures is up for debate, we expect inflation concerns to persist for some months as stimulus actions, commodity prices and reopening feed through. Against this backdrop, we see continued opportunity in the Materials sector.


Inflation is the market’s hottest topic

April’s inflation reports, released last week, have put rising prices in even sharper focus. Market commentators had been anticipating meaningful pressure given the demand-pull drivers of economic reopening and the supply-push impact of COVID-related disruption. Nevertheless, the US CPI report, with consumer prices +4.2% YOY, was much higher than expected and was followed with PPI +6.2% YOY. And while the Chinese CPI figure of 0.9% YOY was relatively muted, some of the moves in factory gate figures (PPI +6.8%) showed the cost pressures from raw materials and implications of reopening that could flow through to other economies. Global semiconductor shortages have also caused supply challenges, for example in the second-hand automotive sector; going forward we could see further drawdown of already lean inventories.

For many investors, inflation overtook COVID as the largest threat to markets back in March. While the transitory nature of some of the pricing pressures is up for debate, especially by the Federal Reserve, we expect inflation concerns to persist for some months as stimulus actions, commodity prices and reopening feed through. Inflation is likely to be stronger in the US, which is facing rapid economic recovery, than in parts of the world that face persistent output gaps. Comments from speakers of the ECB and BoE last week suggested that inflationary pressures are being carefully watched but they are not at US levels.

Inflation pressures are exacerbating the longer-standing concerns of some investors about stretched valuations in stock markets, which leaves expensive growth stocks, such as the FAANGs, vulnerable to short-term weakness. Indeed, the US sectors of Technology, Communication Services and Consumer Discretionary have been the worst performers in the last two weeks. Profit-taking in these sectors is also being driven by the search among more cyclical businesses for beneficiaries of the reopening and recovery of economies as COVID restrictions ease. Beware that the large size of these three sectors could cause a dampening effect on market levels in general.

Materials are meeting the challenge

In the current environment, investors should consider which sectors stand to gain or lose the most from inflationary pressures. It is worth thinking about companies’ pricing power and their ability to pass on higher input costs, part of which depends on the elasticity of demand (be it corporate or retail) from customers as well as the availability of product and supply bottlenecks, which is more relevant now.

Looking at index returns, we see that cyclical sectors (such as Industrials and Materials) tend to outperform defensive ones (such as Consumer Staples) during periods of rising inflation. The strongest relationship, with a correlation to inflation more than three times higher than the market average, is Energy because of the pass-through of higher oil prices. Financials also tend to outperform during periods of higher inflation, with the positive relationship driven primarily by associated timing of interest rate rises. We feature data on the sensitivity of sectors to inflationary expectations of the previous three years in the SPDR Sector & Equity Compass every quarter. 

The pricing power of Energy companies varies according to their position upstream or downstream, but overall the ability to benefit can be seen in the large earnings forecast upgrades in recent months. Even though we see high investor demand for Energy ETFs continuing in the near term, we prefer another commodities sector, Materials, for exposure to the current reflationary environment. While the current demand-supply balance for oil could weaken with any deterioration in the OPEC+ agreement to restrain production, we believe the forces driving industrial metals prices have more longevity.

Prices of metals such as copper, zinc and aluminum are trading at multi-decade highs. Mining companies (36% of the Materials sector) are well placed in the current cycle to pass on these higher industrial metal prices to their customers. Although price increases often stimulate new supply, within this industry, permissioning and building of new mines can take years so current positive demand-supply dynamics could persist. Elsewhere in the Materials sector, chemical manufacturers (50% ) and building product, packaging and paper producers face similar beneficial demand and supply trends. Forecast upgrades have left valuations inexpensive against historical levels, as seen in the chart below.1   

MSCI World Sector – Relative P/E

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Source: State Street Global Advisors, Bloomberg Finance L.P., as of 13 May 2021.

How to access this theme

Investors looking to combat inflation can do so with SPDR sector ETFs. To learn more about these ETFs, and to view full performance histories, please visit the fund pages linked below:

SPDR MSCI World Materials UCITS ETF 

SPDR S&P U.S. Materials Select Sector UCITS ETF 

SPDR MSCI Europe Materials UCITS ETF 

European-Domiciled ETP Segment Flows (Top/Bottom 5, $mn)

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European-Domiciled ETF Asset Category Flows ($mn)

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Source: Bloomberg Finance L.P., for the period 6-13 May 2021. Flows are as of date indicated and should not be relied upon as current thereafter. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future. 

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