Sector Opportunities for Q4 2022

• The oil and gas exploration and production Industry has shown low correlation to the broad market and high beta sensitivity to inflation
• Utilities may help investors navigate economic downturns and potentially benefit from the Inflation Reduction Act of 2022
• With Russia-Ukraine war triggering a paradigm shift in the global geopolitical landscape, the aerospace and defense industry may benefit from a new cycle of increased defense spending

With core CPI inflation and consumer inflation expectations near multi-decade highs,¹ the Federal Reserve has raised the federal funds rates by 2.75% over the course of Q2, bringing the policy rate to its highest level since the global financial crisis. In September’s FOMC meeting, policymakers also raised their median projections for the terminal rate of this hiking cycle to 4.6% from June’s 3.8% and increased their core PCE inflation forecast for next year to 3.1%, indicating that tightening monetary policy and high inflation will likely be with us for a while.²

As the 10- and 2-year part of the curve remains inverted —flashing a warning sign of recession — earnings downgrades probably will continue and equity volatility is likely to be heightened in the near term. In this challenging market environment with looming recession risks, we favor industries with strong profitability or stable earnings, as well as beneficiaries of secular growth trends regardless where we are at the business cycle.

Oil and Gas Explorers and Producers: Portfolio Diversifiers with Strong Profitability and Attractive Valuations

Recessionary concerns and weak Chinese growth have weighed on oil prices since early June, sending WTI crude oil prices below $90 per barrel — more than 25% below their June peak. The oil and gas explorer and producer stocks, as a result, have given back some of their earlier gains, underperforming the broad market by more than 11% over the past three months.³

Recent weak performance combined with solid earnings fundamentals have led to more attractive valuations than earlier this year. The industry now trades at around a 70% discount to the S&P 500 based on forward 1-year price-to-earnings ratio, compared to 48% discount in January.⁴ Its attractive valuations, combined with strong profitability and tight oil and gas supply demand balance may create an attractive entry point for investors who are concerned about inflation and geopolitical uncertainties and want to add a diversifier to their equity portfolios.

Despite recent weakness, oil and gas prices are still well above US producers’ breakeven point, supporting the industry’s profitability.⁵ Even given this year’s high energy commodity prices, US oil and gas explorers and producers have maintained capital discipline. As shown in the chart below, US oil and gas rig counts have barely recovered to their pre-pandemic level and remain well below those during previous oil peaks. Meanwhile, crude oil and natural gas inventories, whether including or excluding strategic petroleum reserve (SPR), are at or near their five-year lows heading into the fall season.⁶ Limited domestic supply amid continued global supply disruption due to the Russian-Ukraine war may support oil and gas prices this winter. Against this backdrop, energy companies continue leading earnings sentiment with strong Q2 earnings surprises and earnings upgrades for this and next year.⁷

August stronger-than-expected CPI inflation data underscored persistent inflationary pressures. The oil and gas exploration and production industry has shown the greatest sensitivity to year-over-year CPI inflation among 21 S&P Select industries,⁸ presenting itself as a powerful tool to defend equity portfolios in an elevated inflation environment. In addition, the industry has had one of the lowest correlations to the broad market since inflation started surging last year,⁹  potentially providing diversification benefits and adding resilience to a core equity portfolio.

To capture strong profitability and attractive valuations in the oil and gas industry, consider the SPDR® S&P® Oil & Gas Exploration and Production ETF (XOP).

Utilities: A Defensive Sector that May Benefit from the Inflation Reduction Act

As economic growth has decelerated sharply and elevated labor and input costs pose headwinds to companies’ profit margins, analysts have been downgrading S&P 500 EPS estimates for this and next year since the start of Q3. However, the Utilities sector has shown a more stable earnings outlook. Since utilities generally pass fuel, operational and maintenance costs to customers and demand for their services is inelastic, high inflation has had little impact on the sector’s bottom line this year. In fact, Utilities is the only sector, barring Energy, that has seen earnings upgrades for this year and stable earnings for next year.¹⁰

Utilities’ defensive business nature has historically helped investors navigate economic downturns and market environments featuring a flattening yield curve. According to our sector business cycle analysis, Utilities outperformed the broad market during all past recession periods by an average of 11% and was one of the three best-performing sectors during recession. Utilities also has historically outperformed the broad market when the yield curve flattens , signaling weak economic growth prospects similar to the current market environment, as shown in the chart below. Over the past 15 years, when the yield curve flattened for the month, Utilities on average outperformed the S&P 500 Index by 1% for 63% of the time. This outperformance is the greatest and the most consistent among the 11 GICS sectors.

Besides near-term macroeconomic tailwinds, the sector may also benefit longer term from the recently passed Inflation Reduction Act of 2022 (IRA 2022). As one of the largest contributors to greenhouse gas emissions in the US, the Utilities sector has felt significant pressure to decarbonize. All of the S&P 500 utilities companies have set interim carbon reduction goals to achieve net zero by 2050 at the latest.¹¹ To achieve those goals, capital expenditure, including investment in electric transmission infrastructure and new clean power generation, is estimated to account for approximately 13% of 2022-2024 spending in the electric, gas and multi-utilities industries.¹² The production and investment tax credit incentives included in the IRA 2022 may help reduce the cost of utilities’ transition to renewable energy resources over the next decade. The addition of renewable assets may also help utilities align their generation mix with states’ environmental goals and customers’ interests, expanding their rate base and providing a new source of earnings growth over the long term.

To prepare portfolios for potential economic downturns and to capture the potential benefits of the IRA 2022, consider the Utilities Select Sector SPDR Fund (XLU).

Aerospace & Defense: A Potential Beneficiary of Increasing Global Defense Spending

After underperforming the broad market by 19% on an annualized basis between 2020 and 2021,¹³ US aerospace and defense stocks jumped on the heels of the Russia-Ukraine war in anticipation of increases in global defense spending, while the broad market was grappling with slower growth and higher inflation. Although the industry pulled back in Q2, the Russia-Ukraine war and rising tensions between the US and China on Taiwan provide significant secular tailwinds for the industry, as these events reflect a paradigm shift in the global geopolitical landscape and may start a new cycle of increasing defense spending globally.

Although the US spends more on defense than any other country in the world, its share of global military spending has declined over the past decade, while China’s share of global spending has steadily increased. Even compared to its own history, the yearly average of US military spending as a share of GDP over the past five years is the lowest since 2000.

The Russia-Ukraine war is a wakeup call for the US and its allies to sustain and strengthen their defense competitiveness. Rising tensions around the Taiwan Strait further reinforced bipartisan support for increasing the defense budget. In July, 180 Democrats and 149 Republicans in the House of Representatives joined forces to approve $37 billion more in defense spending than the $773 billion President Biden had requested for fiscal year 2023, which was already a 9.8% increase over the 2021 enacted level.¹⁴ Meanwhile, the Senate Armed Services Committee has backed a $45 billion increase over Biden’s proposal with bipartisan support and will bring it to the Senate floor for a vote later this year.¹⁵

In Europe, increases in defense spending have lagged behind the US, Russia and China.¹⁶ Since the start of the Russia-Ukraine war, European NATO countries have vowed to accelerate efforts to fulfil their commitment of reaching 2% of GDP on defense spending. Most notably, German lawmakers approved an amendment to the country’s constitution that will create a €100 billion special defense fund to help the country reach the quota over the next five years.¹⁷

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

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