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Spotting Sector Trends

Sector Opportunities for Q4 2023

  • Insurance: Strong pricing power and higher rates support industry’s profitability
  • Oil & Gas Exploration & Production: Attractive valuations and constructive supply-demand imbalance could bolster prices
  • Homebuilders: Recovery continues with a structural demand shift to the new housing market
Senior Research Strategist

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.

Insurance: Strong Pricing Power and Higher Rates Support Profitability

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).

Oil & Gas Exploration & Production: Attractive Valuations with Constructive Supply-Demand Imbalance

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).

Homebuilders: Structural Demand Shift to the New Housing Market

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.

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