Sector Opportunities for Q2 2023

• Non-cyclcial Consumer Staples businesses offer earnings resiliency
• The Homebuilders industry offers attractive valuations in a structurally under-supplied market
• Cybersecurity is a top area of increasing investment in IT budgets

Surprisingly, US equities finished the first quarter on a high note, up 7.5% after a few tumultuous weeks triggered by hotter-than-expected inflation data and emergency government interventions to backstop deposits in the wake of the collapse of Silicon Valley Bank and Signature Bank. The lingering effects from the regional bank turmoil — tighter lending standards and more fragile business sentiment — likely will lead to weaker growth and higher recession risk. Earnings estimates still look too optimistic and equity valuations are too stretched for a soft landing. The silver lining is that the Federal Reserve (Fed) may not need to tighten much more to rein in inflation.

Against this backdrop, we favor Consumer Staples, a defensive position with attractive valuations; homebuilders, a downtrodden cyclical industry with stabilizing fundamentals and historical low valuations; and cybersecurity, a secular growth industry with resilient near-term demand.

Consumer Staples: Non-cyclical Businesses with Earnings Resiliency

Twelve months into the most aggressive rate hike cycle, leading economic indicators continue rolling over into deeply negative territory, pointing to risk of recession. Indeed, the probability of an economic recession in the next 12 months predicted by Treasury spreads spiked to near 60% over the first quarter.¹ While improved economic sentiment in the first two months this year gave investors hope for a no-landing scenario, the recent regional bank turmoil reminded them of the damage intense rate hikes can cause and the growing vulnerability of the economy.

The earnings outlook seems disconnected from this negative macroeconomic backdrop. The earnings per share (EPS) trajectory is still well above its pre-pandemic trend, implying a growth rate of 0.8% for 2023 and 12.5% for 2024, even after analysts lowered 2023 and 2024 EPS estimates by 12% and 9%, respectively, from their peak.² Furthermore, the consensus estimate of operating margin for 2023 is higher than last year and well above the pre-pandemic five-year average.³

These above-trend projections on earnings and profit margin appear far-fetched in an environment with elevated inflation and recessionary prospects. The earnings trend during historical recessions provides context for the downside risk of the current consensus earnings estimates. During the seven economic recessions since 1963, the S&P 500 avoided a greater than 10% decline in earnings just once, in 1980.⁴ Excluding the two deepest declines during the Dot-Com Bubble and Global Financial Crisis (over a 50% drop), S&P 500 earnings declined an average of 16.8%.⁵

Given the increasing recessionary risk and downside risks to earnings revisions, Consumer Staples’ non-cyclical business and earnings resiliency may add value to investors’ portfolios in a challenging economic environment. Amid earnings downgrades across the broad market, Consumer Staples’ earnings outlook has been relatively stable, with 2023 EPS estimates down just 0.5% over the past six months, compared to a decline of 8% for the S&P 500. (See chart below.)

Disinflation in the sector’s input costs, such as packaging, transportation, and agriculture prices that began late last year may also support the sector’s profit margin this year.⁶

After lagging the broad market by 7% in Q1, Consumer Staples’ relative forward price-to-earnings valuations have come down below their long-term median (38th percentile).

As recession risk looms, consider the Consumer Staples Select Sector SPDR® Fund (XLP) for a defensive position with attractive valuations.

Homebuilders: Attractive Valuations in the Structurally Under-Supplied Market

Last year’s aggressive Fed rate hike hit homebuilder stocks the hardest. The spike in mortgage rates and elevated home prices impaired housing affordability, resulting in sharp declines in home sales and construction activities. However, as housing prices start cooling and mortgage rates trend lower, the industry has shown some recent signs of stabilization. February existing home sales beat expectations, increasing 14.5% — the largest monthly gain since July 2020. And with inventory at historic lows, demand has shifted to the new home market. Forward-looking indicators on new construction, including housing starts and permits, are well ahead of February’s estimates ,registering meaningful increases for the first time since last May.⁷ As a result, homebuilder confidence rose for the third straight month in March, with builders reporting better-than-anticipated new home sales and higher traffic of prospective buyers.⁸

The homebuilder earnings outlook is stabilizing against this backdrop. The number of earnings downgrades decreased for the fifth straight month in March to its lowest level in a year.⁹ Thanks to easing supply chain pressures and disinflationary trends in goods, prices of building materials have declined on an year-over-year basis for three straight months to the level of April 2021,¹⁰ turning one of last year’s earnings headwinds to a tailwind. On the demand side, strong labor markets and household balance sheets may support homebuyer confidence once mortgage rates stabilize at a lower level. Homebuilders’ strong Q4 earnings and sales surprises on the back of retreating mortgage rates suggest that once rates peak, homebuyers will jump back into the market.¹¹

Some investors may question the bullish stance in Homebuilders when unemployment rates are expected to be higher and recessionary risks have increased after the regional bank turmoil. We believe the current valuations for homebuilder stocks are pricing in a more serious downturn than our base case where the economy experiences a mild recession without severe job losses and the deflationary process continues so that more dramatic moves in terminal rates can be avoided. Homebuilders are currently trading below their tangible book value — at the lowest level since the 2008 housing crisis, as shown in the chart below. Furthermore, homebuilders’ price-to-tangible-book-value ratio has tended to trough when rates peak, except during the 2008 housing crisis.

As we approach the end of the rate hike cycle, homebuilders may experience valuation expansion. To capture attractive valuations in the structurally under-supplied housing market, consider the SPDR® S&P Homebuilders ETF (XHB).

Cybersecurity: A Top Area of Increasing Investment in IT Budget

Remote work and cloud adoption have accelerated the digital transformation since the start of the pandemic exposing organizations to greater cybersecurity risks. In fact, cybercrime is one of the top 10 global risks ranked by severity over the next two years.¹² While IT budgets have been under pressure amid an economic downturn, investments in cybersecurity have not been targeted for cost cuts, as business leaders understand the significance of cyberthreats and the financial and reputational damages they may cause.

In fact, 91% of business and cybersecurity leaders believe a catastrophic cyber event is likely in the next two years, according to 2023 Global Cybersecurity Outlook by the World Economic Forum. And 43% think the cyberattack will materially affect their own organization. As a result, businesses are dedicating more resources to day-to-day defense. The Gartner Survey of over 2,000 chief information officers reveals that cyber and information security is the top area of increased investment for 2023, surpassing data analytics, cloud platforms, and artificial intelligence.¹³ Spending on information security products and services is projected to grow 11.3% to more than $188 billion in 2023, driven by accelerating growth in application security, cloud security, and zero trust network access.¹⁴

The US government is also strengthening the nation’s cyber-defense through public investment. President Biden’s FY 2024 budget proposal allocates roughly $26 billion to implement the recently released national cybersecurity strategy, including $13.5 billion for the Pentagon to advance its adoption of zero trust architecture and $12.7 billion (a 13% increase over the 2023 enacted level) in funding for federal civilian agencies.¹⁵

Given society’s increasing investment in cybersecurity, companies whose products and services are driving innovation in future security may present long-term growth potential. To capture the broad range of innovative in cybersecurity firms, consider the SPDR® S&P Kensho Future Security ETF (FITE).

To learn more about emerging sector investment opportunities, visit our sectors webpage.