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.
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 8th 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
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).
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.
Earnings Per Share (EPS) A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
Inflation An overall increase in the price of an economy’s goods and services during a given period, translating to a loss in purchasing power per unit of currency. Inflation generally occurs when growth of the money supply outpaces growth of the economy. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
Price-to-Cash-Flow A stock valuation indicator or multiple that measures the value of a stock's price relative to its operating cash flow per share. The ratio uses operating cash flow (OCF), which adds back non-cash expenses such as depreciation and amortization to net income.
Price-to-Earnings Ratio Metric that compares a company's share price to its annual net profits. This ratio can be used to compare companies of similar size and industry to help determine which company is a better investment.
S&P 500® Index A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Valuation The process of determining the current worth of an asset or a company.
Volatility The tendency of a market index or security to jump around in price. Volatility is typically expressed as the annualized standard deviation of returns. In modern portfolio theory, securities with higher volatility are generally seen as riskier due to higher potential losses.
1 Federal Reserve, Summary of Economic Projections, 6/14/2023
2 FactSet, as of 6/20/2023.
3 Reuters, OPEC+ announces surprise oil output cuts, 4/2/2023
4 US Energy Information Administration, as of 6/23/2023
5 Reuters, “Saudi pledges big oil cuts in July as OPEC+ extends deal into 2024,” 6/4/2023
6 FactSet, 10-year beta to the Bloomberg Crude Oil Index is 0.57 for the S&P Oil & Gas Exploration and Production Select Industry Index and 0.45 for the S&P 500 Energy Sector.
7 FactSet, for periods from 3/31/2023 to 6/14/2023.
8 Bloomberg, China Mulls New Property-Market Support Package to Boost Economy, June 2, 2023
9 FactSet, as of 6/20/2023
10 McKinsey, Invasion of Ukraine: Implications for European defense spending, December 2022
11 Politico, The debt deal limits Pentagon spending. Lawmakers are already figuring out ways around it. June 1, 2023
12 Airbus Global Market Forecast, 2023
13 IATA, Global Outlook for Air Transport, June 2023
14 McKinsey, 2/15/2023.
15 Barclays, as of 6/21/2023
16 FactSet, as of 6/21/2023.
Important Risk Disclosure
The views expressed in this material are the views of the SPDR Research and Strategy team through the period ended June 23, 2023, and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
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Aerospace and defense companies can be significantly affected by government aerospace and defense regulation and spending policies because companies involved in this industry rely to a significant extent on U.S. (and other) government demand for their products and services. Thus, the financial condition of, and investor interest in, aerospace and defense companies are heavily influenced by governmental defense spending policies which are typically under pressure from efforts to control the U.S. (and other) government budgets.
Metals and mining companies can be significantly affected by events relating to international political and economic developments, energy conservation, the success of exploration projects, commodity prices, and tax and other government regulations. Investments in metals and mining companies may be speculative and may be subject to greater price volatility than investments in other types of companies. Risks of metals and mining investments include: changes in international monetary policies or economic and political conditions that can affect the supply of precious metals and consequently the value of metals and mining company investments; the United States or foreign governments may pass laws or regulations limiting metals investments for strategic or other policy reasons; and increased environmental or labor costs may depress the value of metals and mining investments.
Stock prices for oil and gas companies are affected by supply and demand both for their specific product or service and for energy products in general. The price of oil and gas, exploration and production spending, government regulation, world events and economic conditions will likewise affect the performance of these companies. Correspondingly, securities of companies in the energy field are subject to swift price and supply fluctuations caused by events relating to international politics, energy conservation, the success of exploration projects, and tax and other governmental regulatory policies. Weak demand for the companies’ products or services or for energy products and services in general, as well as negative developments in these other areas, would adversely impact the Fund’s performance. Oil and gas equipment and services can be significantly affected by natural disasters as well as changes in exchange rates, interest rates, government regulation, world events and economic conditions. These companies may be at risk for environmental damage claims.
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