Sector Opportunities for Q1 2023

• Aerospace & defense industry growth will be supported by the FY 2023 National Defense Appropriation Act which likely marks the start of a new cycle of increased defense spending
• Regional banks show strong profitability, quality balance sheets, and attractive valuations in a favorable interest rate environment
• Pharmaceuticals may provide investors greater exposure to quality and value than the broad Health Care sector
  

US equities ushered in the new year with many headwinds — multi-decade high inflation, continuous monetary tightening, and lower economic growth. While inflation continues to cool l down, it is still too early for the Federal Reserve (Fed) to claim victory over inflation and change to a neutral monetary stance. High inflation and soft aggregated demand will keep downward pressure on corporate profitability. Against this backdrop, we picked three industries with strong industry demand and pricing power, attractive valuations, and high quality traits to position portfolios for the economic downturn without missing the inflection point for the inevitable recovery.

Aerospace & Defense

Last year, US aerospace & defense stocks had their best year in more than 20 years on a relative basis, beating the broad market by more than 30%.¹ But the industry still lags the broad market by 18% from its pre-pandemic level.² As countries continue boosting defense spending amid elevated geopolitical tensions, while the broader economy grapples with softening demand and high inflation, we see potential for further outperformance in the industry for 2023.

Increased defense spending is one of few areas with bipartisan support in the split Congress. In December, the FY 2023 National Defense Appropriation Act (NDAA) was passed with wide bipartisan support, authorizing a record $858 billion in defense spending — $45 billion more than President Biden’s budget request and a 10% increase from the FY 2022 enacted amount.³ If the budget is fully implemented this year, it would be the highest annual growth rate in defense spending in almost two decades.

Besides addressing the effects of inflation, the FY 2023 NDAA increased the funding to assist Ukraine by $500 million from last year and set up a specific defense modernization program authorizing up to $10 billion over the next five years for Taiwan to deter aggression by China.⁴ The FY 2023 NDAA likely marks the start of a new cycle of increased defense spending, as intensifying great power competition and aging US defense systems call for more investment in the coming years to achieve US defense and security goals in a “decisive decade.”⁵

During the last defense spending cycle between 2001 and 2011, the US economy experienced two economic recessions. Supported by the secular increase in defense spending, the aerospace & defense industry showed greater resilience in the challenging economic environment, posting stronger growth than the broad market for most years and outperforming 39% over the broad market on a cumulative basis over the same period.⁶ See the chart below. Similar growth trends are expected for 2023 amid higher demand. Although the industry’s consensus growth estimate for 2023 came down in the second half of 2022, it is still significantly higher than the broad market (46% vs 4%).⁷

While the aerospace & defense industry appears expensive based on price-to-forward-earnings following its strong performance last year, its price-to-book ratio is around its 20-year average.⁸ Relative to the broad market, its price-to-book ratio is at the bottom quintile of the past 20 years and 15% below the median level during the last defense spending cycle, indicating an underappreciated growth opportunity.⁹

To capture the secular tailwinds of increasing defense spending, consider the SPDR® S&P® Aerospace & Defense ETF (XAR).

Regional Banks

US banks posted negative earnings growth for 2022 largely due to the base effect from significant reserve releases in 2021. However, they entered 2023 with record net interest income, higher net interest margin, strong loan growth, and favorable asset quality, thanks to rising interest rates and resilient consumer and business activities. Against the backdrop of the Fed’s aggressive rate hikes, the bank industry saw the largest year-over-year expansion in net interest margin on record in Q3,¹⁰ since the yields on bank assets are more sensitive to higher interest rates than the yields on deposit. Meanwhile, supported by strong growth across a wide range of loan portfolios, banks’ total loan balance grew 9.9% on a trailing 12-month basis — the fastest rate since Q2 2006.

Strong loan growth has not come at the expense of asset quality, as early delinquencies (loans past due 30-89 days) and net charge-off rates hover around historical lows. Given higher economic uncertainty, banks have set aside more reserves to prepare for potential losses, resulting in the highest reserve coverage ratio on record.¹¹

With monetary tightening working its way to the broader economy, we acknowledge that loan growth probably peaked in 2022 and net charge-off rates may start normalizing from post-pandemic lows in a slow growth environment. Nevertheless, given that the yields on banks’ earning assets are still well below their pre-pandemic level when the interest rate was much lower than the current level, and the likelihood of more rate hikes this year, we may see more upside on the net interest margin, supporting earnings growth in the bank industry for 2023.¹² As a result, the industry’s recent earnings outlook has been more stable than the broad market and other cyclical sectors , with less significant earnings downgrades for 2023.¹³

Despite the industry’s solid fundamentals, it is trading at a 41% and 64% discount to the broad market based on forward price-to-earnings and price-to-book multiples, respectively.¹⁴ These relative valuations are within the bottom quintile over the past 15 years and close to their levels during the peak of the Global Financial Crisis, indicating the market is pricing in a deep recession for the industry. Given the industry’s strong balance sheet and favorable interest rate environment, its current valuations may provide investors an attractive value opportunity with more potential for upside surprises under a soft landing scenario.

To capture the bank industry’s strong interest income growth, consider the SPDR® S&P® Regional Banking ETF (KRE), as regional banks are more focused on the lending business and have higher net interest margin than large diversified banks.

Pharmaceuticals

At the beginning of last year, we favored the broad Health Care sector given its high quality and constructive valuations. The sector’s defensiveness attracted strong investor interest, as health care ETFs took in a record $13 billion of inflows for the year, exceeding the second sector category by more than $4 billion.¹⁵ And Health Care did not disappoint investors in terms of performance. The sector beat the broad market by 16%,¹⁶ a trend consistent with its performance history during economic slowdowns.

However, after a year of strong relative performance, the broad Health Care’s relative valuations have become more expensive and now sit at the top quintile over the past 15 years based on forward price-to-earnings.¹⁷ As the economy progresses to the end of the late cycle and transitions to a potential recession, a more nuanced industry level exposure in Health care may provide investors greater exposure to quality and value.

We screened six GICS industries within the S&P 1500 Health care sector — including health care providers & services, health care equipment & supplies, pharmaceuticals, life sciences tools & services, health care technology, and biotechnology — based on valuations and quality metrics. Pharmaceuticals ranks the second-best in terms of both profitability (measured by return on equity and operating margin) and margin stability over the past twenty years, following biotech and health care providers & services, respectively. Its relative forward price-to-earnings valuations are the third-most attractive — behind the health care technology and biotech industries, based on the percentile ranking of each industry’s valuations over the past 17 years.¹⁸

With anticipated lower COVID-19- related revenue and a tough comparison base, pharmaceuticals’ sales and earnings growth is expected to be negative in 2023. Nevertheless, the industry’s strong pricing power and noncyclical demand may better withstand inflationary pressures and a weak economic growth environment. In the current wave of earnings downgrades, pharmaceuticals have shown relatively more stable earnings outlooks than the broad market, as the industry 2023 consensus EPS was downgraded by 3% since August, compared to a 6% decline for the S&P 500.¹⁹ From a regulatory risk perspective, the prescription drug provisions in the 2022 Inflation Reduction Act and a split Congress may reduce the risk of new major drug pricing legislation in the near term.

To provide portfolios more exposures to quality and value, consider the SPDR® S&P® Pharmaceutical ETF (XPH)

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