US equities have been trading sideways following a strong first half year as a resilient US economy contends with rising oil prices and higher long-term yields. Equity valuations, especially among this year’s performance leaders, have been challenged amid higher real yields. Nevertheless, earnings estimates have held up strongly thanks to resilient consumers, materialization of AI-related demand, and residual fiscal stimulus from the CHIPS and IRA Acts.
As we approach the end of the rate hike cycle, earnings fundamentals likely will be the key driver of stock prices. Therefore, we favor industries with improved growth prospects supported by specific industry trends at reasonable valuations: Insurance, Oil & Gas Exploration & Production, and Homebuilders.
The insurance industry had a strong run relative to the broad market last year, as investors favored its strong pricing power and interest rate sensitive business model in a higher rate and inflationary environment. But the performance advantage has narrowed significantly since the regional bank crisis as the industry’s notable exposure to commercial real estate (CRE) and adverse auto claim trends raised investors’ concerns about the industry’s profitability and weighed on its valuations.
However, we think concerns about the industry’s CRE exposure are overdone. First, US insurance companies’ CRE portfolios are well diversified with limited exposure to the most problematic CRE assets — the office sector, which accounts for just 1.95% of the industry’s total cash and invested assets. And insurance companies’ CRE loans are usually high quality with low loan-to-value ratios, which historically has resulted in the lowest default and loss rates in the CRE finance industry.1
The peak of auto claim costs also is likely behind us, given disinflationary trends in used cars. Due to stable demand and a strong pricing environment, property & casualty (P&C) insurers’ net written premium — a key indicator of earned premium for the following year — is expected to increase by high single digits for 2023 and 2024, above the industry’s long-term average.2
With new higher premiums taking effect, easing inflation, and improved investment returns driven by higher rates, P&C insurance companies’ return on equity is projected to improve to 7.8% in 2023 from 3.4% last year and strengthen to 9.3% in 2024.3 Given the constructive operating environment, the industry’s 2023 earnings estimates are near year-to-date highs. And next year’s earnings estimates were upgraded by 4.8% over the summer, compared to little changes for the broad market.4
To capture the insurance industry’s improving profitability, consider the SPDR® S&P® Insurance ETF (KIE).
In last quarter’s Sector Opportunities, we highlighted the potential for tighter oil market balances to bolster the outlook of the oil & gas exploration & production industry for the second half of this year. The narrative has played out over Q3, pushing oil prices to year-to-date highs and driving the significant outperformance of the oil & gas exploration and production industry relative to the broad market since June.5
Despite strong gains, we remain positive on the industry given high oil prices likely will be supported by additional supply tightening and resilient demand through year end. Even after oil prices rallied more than 20% to the $80 range over the summer, Saudi Arabia and Russia announced in early September that they will extend cuts of combined 1.3 million barrel/day until the end of the year and open doors for deeper cuts in the coming months. These coordinated production cuts by the two largest producers in the OPEC+ group show their commitment to stabilize oil prices at a higher level.
Tighter supply comes as world oil demand nears record highs, boosted by air travel recovery, strong US growth, and surging Chinese consumption.6 As a result, the global oil market is projected to be in a substantial deficit through Q4.7 Given these supply-demand dynamics, in August US crude oil inventories showed the largest four-week decline in two years, close to their lowest level over the past five years. Global inventories also remained well below their five-year average.8
Meanwhile, product crack spreads — which measure refiners’ margin by subtracting the purchase price of crude oil from the selling price of finished products — reached a near-record high due to strong demand.9
Against this backdrop, the oil & gas exploration & production industry’s 2023 and 2024 earnings estimates were upgraded in August for the first time since December. Up-to-downgrade ratios are now at a one-year high of 4.2.10
Further sizable gains in oil prices may be more difficult after the recent runup. But stable oil prices at a high level may continue brightening oil explorers and producers’ earnings prospects, which have not been fully priced into the current valuations. The industry’s forward price-to-earnings ratio is around the bottom decile of the past 15 years in absolute terms and relative to the broad market.11
To position for tighter oil market balances, consider the SPDR® S&P® Oil & Gas Exploration and Production ETF (XOP).
Homebuilder stocks have been under pressure as mortgage rates broke above 7% in August — near 20-year highs — raising investors’ concerns about demand damage. While high mortgage rates hurt affordability, significant increases in household formation, strong labor markets, and limited existing housing supply continue to support demand for new construction.
Household formation from 2019 and 2021 reached nearly an unprecedented level driven by significant household growth among millennials.12 On the other hand, housing supply has not kept up with the rising household demand since the housing crisis in 2008. The pandemic exacerbated the shortage and the estimated supply deficit increased from 2.5 million in 2018 to 3.8 million units in 2020.13
In the current high rates for longer environment, existing homeowners are disincentivized to sell and give up their low mortgage rates, constraining existing home supplies and driving demand to the new construction market. As a result, existing home sales dropped to a six-month low, while new home sales rebounded more than 30% from a year ago, exceeding expectations for the fifth time this year.14
Homebuilders’ earnings sentiment has turned around over the past two quarters with upgrades outpacing downgrades and double-digit earnings surprises. Although a recent jump in mortgage rates has tempered down homebuilders’ earnings upgrades, downgrades remain limited. And building permits and early readings of new residential sales for August pointed to better-than-normal seasonality.15
We acknowledge that recent increases in mortgage rates could negatively impact homebuilders’ pricing power and margins. However, the industry’s historically attractive price to tangible book valuations, which is at the lowest level since 2009, may have already priced in the damage of high mortgage rates not reflected by the demand shift to new construction.
With rates peaking, headwinds from higher rates likely will turn into tailwinds. Historically, homebuilders stocks outperformed the S&P 500 index by 104% and 22% respectively in the 12-month period following the last rate hike in all the last three tightening cycles since 1996, except prior to the housing crisis.16 If history rhymes and the labor market remains resilient, recent performance weakness could create a good entry point for investors to position for the structural demand shift to the new housing market.
To capture the continuous recovery in the structurally under-supplied housing market, consider the SPDR® S&P Homebuilders ETF (XHB).
To learn more about emerging sector investment opportunities, visit our sectors webpage.
1 NAIC, U.S. Insurance Industry’s Mortgage Loan Exposure Rises at Year-End 2022 as Commercial Real Estate Trends Deteriorate, August 16, 2023.
2 CFRA, Property & Casualty Insurance Industry Survey, July 2023.
3 Swisse Re Institute, World Insurance: Stirred, and not Shaken, July 2023. Projected characteristics are based upon estimates and reflect subjective judgments and assumptions. There can be no assurance that developments will transpire as forecasted and that the estimates are accurate.
4 FactSet, as of 9/13/2023. The S&P Insurance Select Index is used to represent the insurance industry. The S&P 500 index is used to represent the broad market.
5 FactSet, as of 9/12/2023.
6 IEA Oil Market Report, September 2023.
7 IEA Oil Market Report, September 2023.
8 IEA Oil Market Report, September 2023.
9 IEA Oil Market Report, September 2023.
10 FactSet, as of 9/14/2023.
11 FactSet, as of 8/31/2023. Broad market = S&P 500.
12 Joint Center for Housing Studies of Harvard University, The Surge in Household Growth and What it Suggests About the Future of Housing Demand, January 17, 2023.
13 Freddie Mac, Housing Supply: A Growing Deficit, May 7, 2021.
14 FactSet, as of 7/31/2023.
15 US Census Bureau, Barclays, Zonda Signals Surprising New Residential Strength in August, September 19, 2023.
16 FactSet, for the periods June 2000 – June 2001. July 2006 – July 2007, December 2018 – December 2019.
Important Risk Disclosure
The views expressed in this material are the views of the SPDR Research and Strategy team through the period ended September 22, 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.
Past performance is not a reliable indicator of future performance.
This communication is not intended to be an investment recommendation or investment advice and should not be relied upon as such.
All information is from SSGA unless otherwise noted and has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Investing involves risk including the risk of loss of principal.
Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
When the Fund focuses its investments in a particular industry or sector, financial, economic, business, and other developments affecting issuers in that industry, market, or economic sector will have a greater effect on the Fund than if it had not done so.
Passively managed funds invest by sampling the Index, holding a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the Index.
Insurance companies’ profits are affected by many factors, including interest rate movements, the imposition of premium rate caps, competition and pressure to compete globally. Certain types of insurance companies may also be affected by weather catastrophes and other disasters and mortality rates. In addition, although insurance companies are currently subject to extensive regulation, such companies may be adversely affected by increased governmental regulations or tax law changes in the future.
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.
Homebuilding companies can be significantly affected by the national, regional and local real estate markets. This industry is also sensitive to interest rate fluctuations which can cause changes in the availability of mortgage capital and directly affect the purchasing power of potential homebuyers. The building industry can be significantly affected by changes in government spending, consumer confidence, demographic patterns and the level of new and existing home sales.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.
The trademarks and service marks referenced herein are the property of their respective owners. Third party data providers make no warranties or representations of any kind relating to the accuracy, completeness or timeliness of the data and have no liability for damages of any kind relating to the use of such data.