Insights

Spotting Sector Trends: Sector Opportunities for Q3 2022

  • Insurance firms may provide a defensive rate-sensitive solution to navigate elevated volatility and higher rates
  • Real Estate firms’ improving earnings sentiment may offer durability ahead of the next earnings season
  • Semiconductors may offer long-term growth at a more reasonable price now, given no downside revisions to growth forecasts

Head of SPDR Americas Research

Global equities are in a bear market and recession warnings are growing louder. Broad-based asset class volatility remains elevated, and the S&P 500® Index has posted a daily gain or loss greater than +/-1% on more than 60 days in 2022. Outside of 2020, we haven’t seen so many of these kinds of outsized moves since 1956.1

In addition to the macro forces pressuring markets, fundamental volatility is likely to become more apparent — especially during the early summer months, when earnings season kicks off. That’s when firms will report out on how they are responding to margin compression from inflationary pressure and the impact of a slowing economic growth environment, as well as offer forward guidance on future capital expenditures/growth plans.

In light of ongoing volatility amid rising rates, it may be beneficial to focus on the following:

  • Insurance — a defensive industry with a positive relationship to movements in rates.
  • Real Estate — an industry with positive earnings sentiment may be better able to withstand potential fundamental volatility in the months ahead.
  • Semiconductors — a potential high-growth bargain given the drawdown in stocks, backed by secular long-term tailwinds.

Consider Defensive Rate-Sensitive Industries as Rates Move Higher

Rising short- and long-term rates have been a driving force of market sentiment, putting significant downside pressure on risk assets this spring. The ensuing volatility has led to a reduction in growth projections and an increase in recession fears.

The rise in rates has also weighed on fixed income exposures, as broad core bonds are down double digits in 2022.2 And if we look to bond fund flows (+$37 billion into ultra-short government bond ETFs this year),3 it is clear that investors have sought out market exposures to mitigate the negative impact of the rise in rates on bond portfolios.

Rate-sensitive equity allocations are not as apparent, however; a signal that investors have not taken a full portfolio view when it comes to positioning defensively. This is supported by financial sector equity ETFs, the most rate-sensitive sector, posting $12 billion of outflows in 2022.4

While the average financial sector stock is down 13% this year,5 not all subcomponents have seen the same magnitude of price drop. Based on GICS level three industry groupings, capital markets and banks stocks fell 15%, on average, this year.6 Meanwhile, insurance firms are only down an average 5% — well above returns for the broader sector and market.7

While return trends differ among financials this year, the sector’s long-term sensitivity to interest rates has not changed. And for insurance firms, their positive sensitivity to interest rates comes with a lower overall standard deviation of returns, as shown below. As a result, insurance is likely a more defensive rate-sensitive industry allocation than other subcomponents of the financial sector.

Insurance Firms Show Positive Rate Sensitivity and Lower Overall Volatility

The financial sector is likely to post double-digit declines in earnings growth for 2022, given some hard year-over-year comparable figures. But the earnings profile of insurance firms has been stronger than other financial industries. In Q1, insurance firms posted a decline in growth of just -3% compared to -21% for the entire financial sector.8 And 75% of insurance firms surprised to the upside at an average 7.5% rate, compared to 70% of firms at an average 6% rate for the broader sector.9

Expectations for insurance firms’ future growth have also been more stable — full-year 2022 earnings-per-share forecasts have modestly increased on the year (+0.37%), while forecasts for the broader sector have declined by 2%.10 This is a result of banks’ and capital markets’ expectations for slower overall economic growth and declining markets.

To position for higher rates, but in a defensive manner, consider the SPDR® S&P® Insurance ETF (KIE).

Focus On Sectors With Positive Earnings Sentiment

Fundamental volatility and uncertainty have impacted market sentiment over the last quarter, and that trend is likely to continue. Analyst upgrades-to-downgrades reflect this new, uneven fundamental environment. The number of analysts upgrading 2022 earnings-per-share (EPS) estimates is essentially equivalent to the number of downgrades for US firms. And this ratio has been declining monotonically over the past six months.11

Analysts are not the only ones downgrading expectations — firm guidance has been weaker too. Following the most recent quarter results, more than 70% of S&P 500 firms have issued negative guidance.12 This is above the 60% historic average. As a result, earnings expectations for the second quarter have declined from 5.9% to 4.3%.13

Amid weaker sentiment, firms that were unable to beat lowered estimates were punished more than usual in Q1 — falling 5.1% the day after releasing results compared to the 2.3% five-year average one-day decline.14 This trend underscores the rise of fundamental-led volatility and the need to mitigate this non-macro-related risk moving markets now.

For these reasons, ahead of the next earnings season, it may be beneficial to focus on sectors with positive earnings sentiment. Real estate ranks high on earnings sentiment based on recent analyst upgrades, both in the size and number of upgrades, for 2022 full-year figures.

Sector Earnings Sentiment Scorecard

Energy and materials also rank high based on sentiment. But those higher readings are coming off a low base and are subject to the elevated volatility of specific macro variables (e.g., oil, industrial metal prices). So while earnings sentiment is positive, those sectors could face more macro and return volatility. Real estate is less driven by macro forces, due to its domestic-leaning profile — 83% of the entire sector’s revenue is generated in the US.15

Real estate’s positive sentiment rank is also naturally coupled with supportive growth profiles and expanding margins heading into this next earnings season. Real estate has the highest profit margin of any sector (+36.4%), and 70% of the firms saw margins increase on a year-over-year basis in Q1.16

Additionally, real estate is one of the only sectors (along with energy and materials) to witness upgrades for both Q2 and 2022 full-year earnings and revenue growth.17 And if the past quarter is any indication, those figures are likely to move higher, as more than 75% of real estate firms either beat or met expectations on both earnings and revenue in Q1.18

For exposure to a market with improving earnings sentiment, consider the SPDR® Dow Jones® REIT ETF (RWR).

Look for High-Growth Opportunities, Now Reasonably Priced

With broad-based equities entering a bear market, overall valuations for stocks have improved. In fact, the price-to-next-twelve-months-earnings ratio (P/E NTM) for the S&P 500 Index has now declined below its 30-year average (17.1 versus 18.0).19

The improvement in valuations has been driven primarily by the drop in the numerator, as the market’s P/E NTM has declined by 25% — a rate on par with the performance of the market itself year to date (-18%).20 The denominator (earnings forecasts), however, has remained somewhat stable, modestly increasing on the year even in light of pressing macro risks like rates, inflation, and geopolitical conflict.21

The broad market is not the only segment to see valuations improve. High-growth sectors have seen the most re-rating of valuations, as growth-oriented stocks tend to be longer in duration (i.e., cash flows further out on the horizon). As a result, they are more likely to be negatively impacted by rising rates because of the increase in the discount rate used when calculating the current present value of those far-off cash flows.

One high-tech/high-growth segment that has seen significant improvement in its absolute and relative valuations so far this year is the semiconductor industry. This has been driven by both a reduction in the numerator and a healthy increase in the denominator, the latter having improved above the broader market and the rest of the tech sector.

Based on price-to-earnings ratio and P/E NTM, the semiconductor industry is trading at 13% and 9% discounts, respectively, relative to historical median values over the last 20 years.22 Comparatively, the market and the tech sector are trading at slight premiums to their 20-year medians, as shown below. As a result, relative valuations for semiconductors have also improved.

Semiconductor Valuations Improve Relative to Market and Tech Sector

To add more robustness to this relative valuation argument, we can expand fundamental metrics from two to six.23 Based on a six-factor ensemble fundamental valuation approach, the semiconductor industry trades at a slight premium to the market (17%) but a discount to the tech sector (-24%).24 In both instances, these relative valuations best historical averages, as semiconductors usually trade at a 31% and 1% premium, respectively.25

Despite sluggish growth prospects for tech, semiconductor valuations have not declined. Twelve-month growth forecasts for semiconductor stocks were revised higher by 11% this year, compared to 3.6% and 4.0% for the S&P 500 Index and tech sector, respectively.26 In fact, semiconductor firms are the only subindustry within the tech sector with double-digit revenue and earnings growth forecast for Q2 2022.27 And this growth is starting from a more profitable base, since the semiconductor industry has the highest percentage (94%) of profitable firms out of all subindustries within the tech sector.28

And its short-term high-growth forecasts are consistent with long-term growth forecasts. Analysts expect 21% growth over the next three to five years in semiconductors, compared to just 13% and 15% for the market and broader tech sector, respectively.29 These lofty forecasts are supported by secular tailwinds related to a more digitally connected economy.

Semiconductors, for example, have been a major catalyst of the rise of the autonomous and “software defined” vehicle. In a recent Barclays report, Ford CEO Jim Farley highlighted that “To control a car, we need 3,000 semiconductors.”30 As of today, the total number of processors per car has increased to 50, up from 10 in 2000. That number is likely to hit 60 in the next decade — underscoring demand for specialized technology powered by semiconductors.31

To gain exposure to an industry with high-growth prospects now trading at a more reasonable valuation, consider the SPDR® S&P® Semiconductor ETF (XSD).

To learn more about more sector investing opportunities, visit the sectors webpage.


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