Increases in wages and household assets, coupled with declining unemployment rate and favorable demographic tailwinds, support strong demand for new homes
The metals & mining industry’s constructive valuations may not have captured its growth potential for the coming years given the increased federal infrastructure spending and acceleration of green energy transition
Health Care’s strong balance sheets and reliable earnings may provide resilience to portfolios during the economic cycle transition
Following a year of stellar earnings growth and stock returns supported by unprecedented fiscal spending and monetary accommodation, US equities will face hurdles before reaching their next highs, as monetary accommodation starts being removed to contain inflation and equity valuations are well above their pre-pandemic levels.1 In our 2022 outlook, we favor Quality and Value exposures to navigate this peak-growth environment, as well as REITs, natural resources sectors and banks that may benefit from a higher inflationary environment. In addition, we see three undervalued sector opportunities that may show improved growth prospects for the next few years or exhibit high quality traits to provide resilience during the economic cycle transition.
Homebuilder: Continue to Build
After a slowdown caused by supply chain constrains and labor shortages over the summer, US housing activities and homebuilder sentiment have strengthened in November. Residential starts rose to their second-highest level since the beginning of the pandemic, while building permits, a leading indicator of future construction, climbed back to the level of this spring.2 Despite input cost inflation, homebuilder sentiment moved higher for the third consecutive month on strong demand and tight existing home supply.3 Mortgage purchase loan applications have rebounded since August,4 as even though mortgage rates have moved higher, they remain below their pre-pandemic level. Meanwhile, strong gains in wages and household assets and the declining unemployment rate may support housing affordability and homebuyers’ confidence.
Low Existing Home Inventory and Elevated Homebuilder Sentiment
Favorable demographic tailwinds and post-COVID consumers’ preference for home ownership in the backdrop of a decade-long home shortage, especially for starter homes, bode well for strong demand for new houses in the coming years. Millennials accounted for 67% of first-time home purchase mortgage applications in the first eight months of 2021.5 As they become the largest demographic in the US and reach their peak first-time homebuying age, the demand for entry-level, single-family homes will likely remain high for the rest of the decade.6 However, inventory of existing single-family homes for sales is near record low,7 creating opportunities for new construction to expand.
Strong demand and households’ strong balance sheet may provide pricing power for homebuilders to offset input cost increases and improve profit margin. While a hawkish Federal Reserve may push short-term interest rate higher in 2022, the effects on long-term interest rates and mortgage rates are nonlinear. Given the current historically low mortgage rates and limited number of potential rate hikes for 2022, this could create urgency among buyers to enter the market, spurring demand in the near term and providing upside surprises on homebuilders’ top-and bottom-line growth in the coming quarters.
Despite its outperformance over the broad market by 16% in 2021,8 homebuilder valuations remain constructive, with forward price-to-earnings (P/E) at the bottom 12th percentile and relative valuations based on forward P/E and price-to-book ratios near their lowest levels since 2008.9 To position portfolios for continued growth of the homebuilding industry, investors may want to consider the SPDR® S&P® Homebuilders ETF (XHB), as it provides broad coverage to the housing industry – ranging from homebuilders and building products to home improvement related areas.
Metals & Mining: Beneficiary of Infrastructure Investment and Green Energy Transition
After outperforming the broad market by 26% for the first five months in 2021, the metals and mining industry has been struggling to sustain its outperformance amid prospects of a demand slowdown driven by weaker growth in China. The industry valuation based on forward P/E was compressed to near its 15-year low, 55% below its historical average.10
While earnings growth is expected to moderate in 2022 due to the base effect, the industry’s growth prospects for the coming years have been boosted by the passage of the $1.2 trillion bipartisan infrastructure bill and the acceleration of green energy transition. The 2021 Infrastructure Investment and Jobs Act includes more than $200 billion of new federal spending on metal-intensive infrastructures such as highways, rail roads, bridges and ports over the next five years.11 More importantly, the bill includes Buy American provisions which require federal-aid infrastructure programs to use American-made iron, steel, aluminum and manufactured products and construction materials with certain exceptions, potentially boosting domestic metal demand.
Over the longer term, the rapid adoption of clean energy technologies implies a significant increase in demand for most metals. For example, a typical electric car requires six times the mineral inputs of a conventional car, and an onshore wind plant requires nine times more mineral resources than a gas-fired power plant.12 As shown in the chart below, based on the existing energy transition policies, the global demand for minerals used by clean energy technology would double by 2040. Achieving the goals of the Paris Agreement (well below a 2°C global temperature rise) would increase mineral demand by four times by 2040. This surging demand could lead to persistent high prices, as it typically takes years and intensive investment to discover and produce critical minerals for clean energy.
Mineral Demand for Clean Energy Technologies by Green Transition Scenarios
The metals and mining industry has underperformed the broad market by 354% on a cumulative basis over the past decade.13 The industry’s constructive absolute and relative valuations may not have captured its growth potential for the coming years given the increasing demand from infrastructure investment and energy transition. To position for the next metal super cycle, investors may consider investing the SPDR® S&P® Metals and Mining ETF (XME).
Health Care: Quality Exposure at a Discount
The Health Care sector lagged the broad market again in 2021,14 as investors positioned toward cyclical sectors that benefited the most from the strong economic rebound. However, as earnings growth is expected to decelerate and monetary policies start normalizing this year, high quality and reasonable valuations may become a bigger focus in investors’ portfolios. Health Care’s strong balance sheets and reliable earnings, coupled with constructive valuations, may help investors manage the transition of economic cycles.
Over the past few months when the S&P 500 earnings growth estimates for 2022 were downgraded, the Health Care sector has shown stronger earnings sentiment, with 2022 EPS raised by 5.4%, the third-highest upward revision among 11 GICS sectors.15 While the surge in new variant cases created bumps for earnings recovery of health care providers and medical equipment and supply companies in 2021 due to staff shortages and reduced volume of elective procedures, demand for diagnostic testing, vaccine distribution, newly approved oral antiviral pills and other medical treatments for COVID-19 supported earnings growth for the overall Health Care sector. As our healthcare system becomes better equipped to deal with the pandemic, disruptions caused by COVID outbreaks may get shorter and less severe, which may lead to more inpatient hospital admissions and elective procedures outside of COVID-related treatment this year, bolstering profitability of the broader Health Care sector.
Investors may also turn into Health Care for its quality traits as the economic cycle matures. The sector usually exhibits less financial leverage, higher profitability and more earnings stability than most other sectors as evidenced in their higher free cash flow to debt ratio, higher return on equity and more stable year-over-year earnings growth.16 These quality attributes have historically been favored by the market when economic growth passed its peak. According to our sector business cycle analysis of the past 12 slowdown periods, Health Care outperformed the broad market nine times, including three slowdown periods after the global financial crisis, by an average of 5%.
Compared to other high quality sectors, such as Technology and Communication Services, Health Care has exhibited more constructive valuations. As shown in the chart below, the sector is trading at a 18% discount to the broad market, presenting a quality exposure with attractive valuations and alleviating investors’ concerns about multiple compression in a more constrained monetary environment. To blend quality and value in a tactical sector exposure, investors may consider the Health Care Select Sector SPDR® Fund (XLV).
Health Care Forward P/E Valuations Relative to the S&P 500 Index
To learn more about emerging sector investing opportunities, visit our sectors webpage.
1 Robert Shiller Online Data Library, based on Case-Shiller Cyclically Adjusted P/E Ratio (CAPE), as of December 31, 2021. 2 Bloomberg Finance L.P., as of December 28, 2021. 3 National Association of Home Builders, as of December 15, 2021. 4 National Association of Home Builders, as of December 22, 2021. 5 Millennials Are Supercharging the Housing Market, WSJ, December 14, 2021. 6 Housing Supply: A Growing Deficit, Freddie Mac, as of May 7, 2021. 7 National Association of Realtors, as of November 30, 2021. 8 FactSet, as of December 31, 2021. 9 FactSet, as of November 30, 2021. The homebuilder industry is represented by the S&P Homebuilders Select Industry Index. The broad market is represented by the S&P Composite 1500 Index. 10 FactSet, as of November 30, 2021. 11 Steel, aluminum demand to see boost on passage of long-awaited US infrastructure package, S&P Global Platts, as of December 1, 2021. 12 The Role of Critical Minerals in Clean Energy Transitions, May 2021, IEA. 13 Bloomberg Finance L.P., as of December 31, 2021. The metals and mining industry is represented by the S&P Metals and Mining Select Industry Index. 14 Bloomberg Finance L.P., as of December 31, 2021. 15 FactSet, as of December 31, 2021. 16 FactSet, as of December 31, 2021. Based on 5-year average of free cash flow to debt ratio, return on equity and 5-year standard deviation of trailing-twelve-month earnings growth.
Price-to-Earnings Ratio (P/E)
A fundamental ratio comparing the current price of a stock to the earnings-per-share of the firm.
S&P 500 Index
The version of the popular benchmark for US large-cap equities that includes 500 companies from leading industries and captures about 80% coverage of available market capitalization in the US that reflects returns after reinvestment of dividends.
One of the basic elements of “style”-focused investing that focuses on companies that may be priced below intrinsic value. The most commonly used methodology to assess value is by examining price-to-book (P/B) ratios, which compare a company’s total market value with its assessed book value.
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