Sector Opportunities for Q3 2023

• Oil & Gas Explorers and Producers: Tighter oil market balances may further strengthen companies’ profitability and balance sheets
• Metals & Mining: Attractive valuations and more economic stimulus from China have improved the industry’s risk-reward profile
• Aerospace & Defense: The secular increase in defense spending and cyclical recovery of commercial aircraft demand create opportunity for growth

The US economy remains resilient amid tightening monetary policy, thanks to strong labor markets and consumer spending. Earnings sentiment also has improved, supported by expectations of a strong Q4 earnings rebound for a few mega-cap technology stocks.

However, given their significant multiple expansions over the past few months and Federal Reserve guidance that suggests more rate hikes are likely by year-end,¹  we think better risk/reward tradeoffs can be found in three underappreciated industries that may benefit from industry specific cyclical tailwinds: Oil & Gas Explorers and Producers, Metals & Mining, and Aerospace & Defense.

Oil & Gas Explorers and Producers: Tighter Oil Market Balances Bolster Outlook

Stocks of oil & gas explorers and producers have declined 3.8% year to date, lagging the S&P 500 by 20%,²  as waning momentum from China’s reopening and slowing global manufacturing activity softened energy demand and weighed on oil prices.

Current oil market balances are tight. OPEC+ production cuts of 1.16 million barrel/day (mb/d) began in May.³  And after increasing to its highest level since June 2021 in March, the US crude oil inventory declined steadily over Q2⁴ despite the release of nearly 20 million barrels from the Strategic Petroleum Reserve (SPR). Saudi Arabia’s surprise production cut of 1 mb/d starting in July and the Department of Energy’s plan to refill the SPR beginning this June⁵ could create a bigger supply deficit during the summer travel season when oil demand tends to rise.

Meanwhile, domestic production has been constrained, as the industry has focused on financial discipline and returning capital to shareholders. Even when oil prices were at their eight-year highs last year, US oil and gas rig counts recovered only to their pre-pandemic level, well below those of previous oil peaks.

Therefore, if oil prices move higher on a global supply shortage this summer, domestic production likely will be unable to fill the supply gap.

Potential higher oil prices may further support the industry’s profitability and strong balance sheets. Already the industry has decade-low financial leverage and record-high return on equity — two high quality attributes. Finally, recent weak performance has created attractive valuations. The industry forward P/E multiple is at the bottom 8^th percentile since 2006, presenting investors a quality exposure at a low price.

To pursue the upside potential of oil prices in the second half of this year, consider the SPDR® S&P® Oil & Gas Exploration and Production ETF (XOP), which has exhibited higher beta to oil prices than the broader energy sector.⁶

Metals & Mining: Improved Risk-Reward Profile With Long-term Growth Potential

The Metals & Mining industry’s relative performance historically has tended to move along with 10-year Treasury yields, as higher long-term yields generally indicate a strong economic growth outlook that supports demand for metals. But the two have decoupled recently, with 10-year yields increasing to near 4% from their lows in March while Metals & Mining underperformed the broad market by 8% over the same period.⁷ See the chart below.

Negative earnings sentiment on the back of weak Chinese economic data has weighed on the industry’s valuations, as its Forward-Price-to-Earnings and Price-to-Cash-Flow ratios now sit around their bottom decile over the past 17 years, pricing in a significant downturn. As China’s recovery from the pandemic lost momentum in Q2, dragged down by the sluggish property market and slowing industrial activity, the earnings optimism analysts had at the beginning of the year quickly faded. Now downgrades, outpacing upgrades, have reached a year-to-date high.

But more stimulus by the Chinese government in the second half of this year could brighten the metal demand outlook and turn the industry sentiment around. The Chinese central bank did cut key policy rates in June, reaffirming its easing stance. The central government is also stepping up plans to stimulate the economy and support the housing market, including potential billions of dollars in new infrastructure spending, relaxing restrictions for residential purchases, and lowering mortgage rates.⁸  Increasing infrastructure investment and a rebound in home sales may buoy demand for metals, supporting higher metal prices.

If 10-year yields stay elevated and China’s economic growth surprises to the upside, the Metals & Mining industry may close the performance gap with the broad market in the second half of this year. Its attractive valuations not only improve its risk-reward profile for the near term but also create a good entry point for investors to pursue its long-term growth potential driven by the accelerated green energy transition and supply chain onshoring.

To position for the rebound in the metals & mining industry, consider the SPDR® S&P® Metals and Mining ETF (XME).

Aerospace & Defense: Increasing Defense Budgets and Recovery in Travel to Fuel Growth

In our sector opportunities for Q1, we highlighted the new cycle of increasing defense spending and the aerospace & defense (A&D) industry’s earnings resiliency amid a challenging economic environment. Despite the industry’s lagging performance,⁹  we maintain our positive outlook.
In the defense segment, the global trend of increasing defense funding remains intact. In Europe, more NATO countries have committed to meeting or exceeding the target of 2% of GDP on defense spending. Therefore, European defense spending is projected to increase between 53% and 65% through 2026, compared to a 14% increase if the Russia-Ukraine war had not heighted European security concerns.¹⁰

Although the defense budget will be capped at what President Biden requested for fiscal 2024 as a result of the debt ceiling resolution, that $886 billion still represents a 3.3% increase over the FY 2023 budget. Some Democrat and Republican lawmakers have already started looking for ways to boost defense funding, potentially through the next emergency supplemental for Ukraine.¹¹

The pent-up replacement of older aircrafts and strong rebound in passenger air travel likely will translate to greater demand for commercial aircrafts in the next few years. After three years of slow retirements of older aircrafts, airlines are modernizing their fleets. The catch-up effect is estimated to increase replacements to 17,170 worldwide in the next 20 years, which is 11% more than the previous estimate and 42% of projected new deliveries.¹²

Meanwhile, the momentum of air travel recovery remains strong, supported by greater increases in international travel, as shown below. The strong demand is expected to continue through 2024,¹³  requiring more new aircrafts in service and benefiting commercial aircraft manufacturers and suppliers.

The industry currently has a firm order backlog for 9,400 passenger aircraft through 2027,¹⁴ with the expected future flurry of new orders evidenced by a record number of orders announced during the Paris Air Show in June.¹⁵ To meet the demand, aircraft manufactures have planned to shore up production capacity to historically high rates for the next five years.

With increasing production and strong demand recovery, the A&D industry is expected to show higher earnings per share (EPS) growth than the broad market¹⁶ and may beat high earnings expectations in the coming quarters.

To capture the secular increase in defense spending and cyclical recovery of commercial aircraft demand, consider the SPDR® S&P® Aerospace & Defense ETF (XAR).

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