Market Commentary | June 6, 2021

Schwab Sector Insights: A View on 11 Equity Sectors

Schwab Sector Insights: A View on 11 Equity Sectors

“Schwab Sector Insights: A View on 11 Equity Sectors” provides detail on our three- to six-month outlook for 11 stock sectors, which represent broad sectors of the economy. It is published on a monthly basis and is designed for investors looking for tactical ideas. For more information on our current views, read the latest Schwab Sector Views.

Sector Overview

Source: Schwab Center for Financial Research, as of 06/03/2021. See "Important disclosures" for an explanation of the Macro, Value, Fundamental and Relative Strength factors. The relative performance of the “Outperform” and “Underperform” Schwab Sector Views is total return of the respective sectors relative to the total return of S&P 500 index since the announced inception date of our view through 06/03/2021. A positive (negative) total return reflects outperformance (underperformance) of the sector relative to the overall S&P 500 Index. Past performance is no guarantee of future results.

 

Communication Services: Marketperform

 

The Communication Services sector includes telecommunication services providers, media (e.g., television, radio, print publications, advertising), entertainment (e.g., movie production, sports teams, streamed content), and interactive media (e.g., social networking websites, video games).

Pandemic-related stay-at-home behaviors have been good for some of the companies in the sector, as it has led to increased use of social media and demand for streaming entertainment—though the pace of enrollments is likely to ebb as traditional entertainment options reopen. With the shift from traditional TV and cable, advertisers have struggled but are quickly pivoting toward online mediums. Wireless service revenues and equipment sales are being supported by the initial rollout of fifth generation (5G) cellular technology. While the larger social media companies (Alphabet/Google and Facebook) enjoy significant competitive advantages due to their dominance in their respective business lines—search engine and social media—they also face emerging antitrust risks, as well as potential market saturation.

Longer term, we believe the continued expansion of 5G could further increase growth within the sector, as it continues to increase demand for equipment and services. Upgrading networks will require substantial capital investment, but federal government infrastructure initiatives could result in subsidies and investment.

Positives for the sector:

  • The competitive advantage for social media;
  • 5G rollout should boost growth potential; 
  • Government infrastructure investment should ease 5G capital expenditure burden; 
  • Strong streaming entertainment enrollments, but the pace has likely peaked.

Negatives for the sector:

  • The antitrust regulatory trend is negative for the search engine and social media companies.
  • There is the potential for increased social media regulation (for example, Section 230 legal shield is under scrutiny).
  • Streaming services risk market saturation.

Risks for the sector:

  • Sector market capitalization is heavily concentrated in the top two stocks—Facebook and Google—whose movement can significantly influence the sector.

 

Consumer Discretionary: Marketperform

 

 

The Consumer Discretionary sector includes internet retailers, automobiles and parts, household durable goods (e.g., refrigerators, washers/dryers), consumer durable goods (e.g., televisions, home audio equipment), leisure products (e.g., sports equipment, bicycles, toys), apparel, luxury goods, footwear, casinos, hotels, fitness centers, restaurants and bars.

The Consumer Discretionary sector—which is typically sensitive to swings in the economy—had its winners and losers with the onset of the COVID-19 pandemic. The massive stimulus efforts and stay-at-home orders spurred a surge in spending on home improvement and e-commerce sales early in the crisis—and the related stocks led the equity market rally.

Now, with vaccine distribution expected to be substantially completed soon, even the most beaten-up stocks in the sector—like those in the apparel and hotel industries—have recovered and in many cases extended well beyond pre-crisis price levels. The cruise industry is the exception. But these industries are often overshadowed by bigger companies in the sector—like Amazon and Tesla—that constitute more than 40% of the sector’s market cap. The longer-term trend toward e-commerce and electric vehicles is likely to continue to support the fundamentals of these growth industries, but investor enthusiasm may have pushed valuations too high.

Although higher interest rates are in part reflecting stronger economic expectations, they can weigh on investors’ perceived value of future earnings. Additionally, a severe semiconductor shortage is becoming a significant risk to the production of many consumer electronics and vehicles.

Positives for the sector:

  • Vaccine distribution and ongoing economic recovery are positive for many of the more traditional discretionary industries.
  • The shift away from brick-and-mortar is likely to continue to support the fundamentals for online retailers.
  • Pro-cyclical macroeconomic tailwinds when the economy is strong—though the sector hasn’t traditionally been a strong performer in the expansion phase of the business cycle. 

Negatives for the sector:

  • The sector is overly concentrated in internet retail and automobiles.
  • Valuations and investor enthusiasm appear stretched; higher interest rates can weigh on both.
  • Semiconductor shortages weighing on auto and consumer electronics production.

Risks for the sector:

  • Antitrust action is possible for the largest online retailer.

 

Consumer Staples: Underperform

 

The Consumer Staples sector includes food, beverage and tobacco products; and food distributors (e.g., supermarkets, hypermarkets); non-durable household goods (e.g., detergent and diapers) and personal products (e.g., shampoo and cosmetics).

The ongoing recovery in the economy and shift toward cyclical sectors has resulted in underperformance of the sector since the market low in March 2020—as would be expected for a defensive sector whose constituents are typically less affected by changes in the business cycle. However, with the prospects of reduced social distancing and full reopening of restaurants, food wholesalers that service restaurants have regained some footing, but at the expense of some big-box stores. In general, retailers within the sector have aggressively cut costs, leaving them in reasonable financial condition. But limited pricing power in a low-interest-rate environment gives them less–than-exciting top-line growth potential—though this could change if inflationary pressures prove to be enduring and higher cost can be passed on to consumers.

With additional fiscal stimulus, rollout of the vaccines, and accommodative monetary policies, we think the economy has shifted into the expansion phase. At this stage of the business cycle, the consumer staples sector typically underperforms the overall market. We think growing confidence in the economy will continue to weigh on relative performance going forward—though perhaps excessive exuberance in the markets could spark volatility that would favor the defensive sector. 

Positives for the sector:

  • It typically has a stable earnings profile.
  • Companies have engaged in aggressive cost-cutting.
  • Restaurant openings are supporting wholesale food demand.

Negatives for the sector:

  • An improving economy and strong stock market historically typically make this defensive sector relatively less attractive to investors.
  • Companies tend to have limited pricing power in a low-inflation environment.

Risks for the sector:

  • The additional government stimulus and successful distribution of the COVID-19 vaccines could further support the economy and reduce stay-at-home food and staples demand.
  • The sector could perform better than expected if inflationary pressures enable more pricing power.

 

 

Energy: Outperform

 

 

The Energy sector includes oil and gas drilling, equipment, exploration, refining, marketing, storage and transportation; and coal mining and production.

A confluence of factors has increased the likelihood for the energy sector to outperform the overall market, in our view. The fundamental backdrop has improved significantly. Growing demand for oil and constrained supply are weighing on inventories and bolstering oil prices, and energy companies are being more disciplined with expense and investment—together supporting attractive valuations.

Meanwhile, economic growth is likely to be strong as we enter the “expansion” phase of the business cycle. This is a period during which cyclical value stocks—those that tend to be sensitive to economic shifts, and which may be trading below their intrinsic value—often outperform. Although historically Energy tended to outperform as economic growth peaks and moves into the “slowdown” phase, the sector has become more value-oriented in recent years, so we’re seeing those stocks outperform earlier in the economic cycle.  

There are numerous headwinds for the Energy sector, to be sure. One is obviously the movement toward clean energy, which could imperil the bread-and-butter fossil-fuels business of energy companies. While this is a long-term risk that gives the companies time to transition to renewable energy, renewable energy activists have recently won energy company board seats. More pertinent risks for our three- to six-month outlook include an incremental rise in regulations, potential surge in the supply of oil, another round of COVID-related drag on demand, and overall market volatility.     

Weighing the issues, we believe the Energy sector is poised to outperform during the next three to six months.

Positives for the sector:

  • Oil prices are being supported by improving demand, curtailed supply and a drawdown in inventories.
  • Large diversified energy companies have strong balance sheets and have become more disciplined with expense and investment management.
  • The ongoing recovery of the global economy and expansion phase of the U.S. economic cycle bodes well for returning oil demand.
  • Valuations are attractive relative to other sectors.

Negatives for the sector:

  • Increasingly onerous regulatory environment—though implementation is likely to be measured. 
  • U.S. oil and gas majors have been slow to shift towards clean energy—but potential subsidies might encourage greater adoption of renewables.
  • Shareholder activism has risen.

Risks to the sector:

  • Easing in Iranian sanctions could increase oil supply and weigh on prices.
  • OPEC’s current supply agreement could fail if prices rise much higher.
  • Numerous risks to global growth stemming from COVID or geopolitical flareups; 
  • A significant rise in market volatility;
  • Trend toward clean energy to reduce oil demand in the long term.

 

Financials: Marketperform

 

The Financials sector includes banks, savings and loans, insurers, investment banking, brokerages, mortgage finance companies and mortgage real estate investment trusts.

We’ve recently downgraded our rating on the Financials sector to “marketperform” from the previous “outperform” rating that had been in place since June 2020.

The Financials sector still has many favorable attributes, but several red flags have emerged. Macroeconomic conditions remain favorable for cyclical value stocks, which are heavily represented in the Financials sector. However, this interest-rate-sensitive sector may already have priced in much of the expected near-term rise in interest rates, as investors rushed into the best performing sector over the last 12 months. While we think that rising rates may again become a tailwind for the Financials sector, it could take some time for this to happen.

In general, companies in the Financials sector still boast strong balance sheets, with ample capital to withstand even a significant rise in loan defaults. While the expiration of stimulus payments likely will contribute to an uptick in loan defaults, reserves for a large spike in loan loss were set aside last year—and not needed. Many banks are now able to reverse some of those reserves, which were booked as expenses.

However, despite a rise in longer-term interest rates in the past year, a surge in cash deposits combined with stagnant loan growth is weighing on its bread-and-butter net interest margins (the money they earn reinvesting cash in the short-term money markets, and/or the difference between the rate they pay to depositors and the rate they charge for loans).

Valuations are still attractive relative to other sectors—but forward earnings expectations have flattened out. Unless forward estimates turn higher, any significant price rise in the Financials sector would increase the price/earnings ratio—eroding the attractiveness of its valuations

Many of the sector’s favorable attributes—strong financial position, cyclical tailwinds with higher interest rates, and attractive valuations—drove Financials’ outperformance during the past year. However, investors’ enthusiasm for the sector may have become too frothy, pushing it to an overbought level that historically has been followed by price consolidation.

To be clear, we do not have a negative view on the sector, though there are notable risks (see the risk bullets below). It still has strong underpinnings, and many of the issues noted above could be resolved in the coming months; if they were, our view could change. However, from a three- to six-month tactical perspective, we think outperformance of the sector is less likely.

Positives for the sector:

  • Strong financial position due to stringent post-2008 regulations;
  • The sector has attractive valuations relative to its historical average and other sectors, but earnings growth expectations have flattened out.
  • High loan loss reserves are being released due to low default rates amid strong economic growth (supports earnings growth).

Negatives for the sector:

  • High cash levels and low loan demand are hampering revenues—though improving consumer and business confidence could renew loan growth.
  • Sector appears to be overbought after strong recent performance.
  • Shares may have outpaced the rise in interest rates.

Risks for the sector:

  • The Fed unexpectedly tapers its bond-buying programs and raises short-term interest rates in response to an inflation surge, threatening economic growth.
  • Interest rates plateau or decline on weaker-than-expected economic growth.
  • There is a significant increase in banking regulations.

 

Health Care: Outperform

 

 

The Health Care sector includes hospitals, nursing homes, health care equipment and supplies, health care services (e.g., dialysis centers, lab testing) managed-care plans (e.g., health maintenance organizations, or HMOs), health care technology, pharmaceutical, biotechnology and life sciences companies.

Heading into the 2020 election, the Democratic Party’s health care proposal seemed to be major source of the angst. President Joe Biden’s proposed “public option”—a more affordable, or free, alternative to private health insurance—and enhancements to the Affordable Care Act (ACA) raised questions about the sustainability of profit growth in the health care sector.

However, the Democrats have a razor-thin majority in the new Congress, and division between progressive and moderate Democrats could very well result in many of the more contentious health-care initiatives being much tamer or blocked altogether.

These more benign scenarios open the potential for renewed outperformance based on the long-term positives, including an aging global population and a growing middle class in emerging markets, all of whom will demand more extensive drug treatments and medical care over time. Valuations are relatively attractive, and balance sheets in the sector are generally in good shape, increasing the possibility of higher dividend payments, share-enhancing stock buybacks, and M&A.

There are still risks, however. Any legislation to control drug prices or raise corporate taxes could weigh on pharmaceutical companies’ profits—though promising pipeline drugs can mitigate these risks. Additionally, the Supreme Court is expected to rule on the constitutionality of the individual mandate provision of the ACA in 2021, and that could lead to the entire ACA being repealed. However, in the opening arguments heard in November 2020, the majority of the justices indicated that a total repeal was unlikely, and there is little political appetite to allow disorder throughout the health-care system.

Positives for the sector:

  • Strong balance sheets, with ample cash for dividends and M&A;
  • Positive long-term demographics trends, including an aging global population and a growing middle class in emerging markets;
  • Return in demand for elective procedures, drug sales, medical equipment and diagnostics;
  • Valuations are attractive relative to the sector's historical average.
  • Biotech and pharmaceuticals have strong drug development pipeline.

Negatives for the sector:

  • Extended-care facilities have seen a decline in enrollments and are likely to see higher costs related to virus mitigation requirements.
  • Defensive sector during an economic expansion—though this was not an impediment in the previous cycle.

Risks for the sector:

  • Supreme Court ruling on constitutionality of the Affordable Care Act (ACA);
  • Prescription drug price controls and ACA expansion;
  • Reversal of the 2017 corporate tax cut;
  • Surge in COVID-19 could reduce demand for elective medical care;
  • New competition by Amazon.

 

Industrials: Marketperform

 

 

The Industrials sector includes aerospace and defense (e.g., airplanes, defense equipment) building products, electrical components and equipment, construction machinery, and services including transportation (e.g., airlines, railroads, trucking), construction, engineering and professional services.

With the economic recovery and continued growth, the markets have been trading as would be typically seen in an early and now expansion stages of the business cycle—which can be positive for this historically pro-cyclical Industrials sector. Additionally, prospects for an increase in infrastructure and clean-energy investment will likely support the machinery and building materials industries.

Transportation and air freight have benefited from a return in demand as economies reopen, in addition to relatively low fuel prices and interest rates—though the latter two are rising modestly. The aerospace and defense industry continues to face significant headwinds amid expected low airliner demand and uncertainty surrounding the political appetite for defense spending. But the fundamentals of the sector overall remain positive. While the path of the economy is providing a nice macroeconomic tailwind for the sector, valuations are extended after strong relative performance.

Positives for the sector:

  • Capital expenditures are likely to increase if global growth continues to improve.
  • The sector tends to outperform in the recovery and expansion phases of the business cycle.
  • Many companies have solid fundamentals amid risings earnings expectations.
  • Strong global trade and increase in online shopping are spurring demand for transportation.

Negatives for the sector:

  • Capital expenditures have been tepid.
  • Aircraft demand is likely to be weak until business and leisure travel resumes.
  • Valuations are relatively unattractive after strong relative performance.

Risks for the sector:

  • While we’re currently neutral on the sector, if there is a stronger-than-expected surge in global growth or massive infrastructure stimulus, then it could perform better than expected.

 

Information Technology: Marketperform

 

The Information Technology sector includes software and services, technology hardware and equipment (e.g., mobile phones, personal computers), semiconductors and semiconductor equipment.

Information technology is a highly concentrated sector, with just a handful of companies representing more than 50% of the sector’s weight—including the two behemoths Apple and Microsoft. While those are typically the primary driver of sector performance, impacts related to COVID-19 have been broad-based and positive for much of the sector, increasing consumer demand for PCs, gaming hardware, software, personal devices and online payment services (although at the expense of traditional credit card services by Visa and MasterCard).

Following a dearth in capital spending, there are signs that investment in cloud and networking equipment is picking up, which could persist if the economic recovery continues. Also, the ongoing rollout of 5G wireless infrastructure is likely to accelerate—increasing demand for telecommunication components and semiconductors. A significant short-to-intermediate risk is the supply chain issues, which is proving to be significantly problematic for sourcing semiconductors. 

Longer term, a trend away from globalization and pent-up demand for productivity-enhancing technologies are likely to improve the already solid financial position for much of the sector. Counterbalancing the strong fundamentals, investor optimism about future growth potential has pushed valuations to well above the historical average; higher interest rates can weigh on investors’ perceived value of future earnings. Additionally, there are rising legislative and antitrust risks for some of the largest companies in the sector. Finally, strong price momentum during the COVID crisis has faltered in recent months.

Positives for the sector:

  • 5G rollout and onshoring trends are themes that support fundamentals.
  • Generally strong balance sheets and earnings growth potential with low funding costs;
  • Financial services technology and surging online retail sales are supporting cloud computing infrastructure and software;
  • Long-term growth tailwinds, as businesses enhance productivity with tech investment.

Negatives for the sector:

  • Valuations are very stretched relative to the historical average, making higher interest rates a significant headwind.
  • Capital expenditures are weak but have an improving outlook—particularly with the prospects of technology infrastructure spending. 
  • Semiconductors are in short supply amid very low inventories and strong demand.
  • The sector is highly concentrated in a few stocks.

Risks for the sector:

  • Potential antitrust suits in the U.S. and Europe;
  • Reversal of the 2017 corporate tax cuts that had benefited the sector.

 

Materials: Marketperform

 

 

The Materials sector includes companies that make or process chemicals, construction materials (e.g., bricks, cement), containers and packaging (e.g., metal, glass, plastic, cardboard), forest products (e.g., lumber, paper), and metals and mining (e.g., aluminum, steel, copper, gold, silver).

The Materials sector is sensitive to fluctuations in the global economy, the U.S. dollar, and inflationary pressures. Accommodative monetary and fiscal policies are underpinning global economic growth and pricing power. In this environment, the U.S. dollar has trended lower, which historically provides a strong tailwind for the sector.

The cyclical-value characteristics—which we expect to do well amid improving global growth—are also a tailwind, and there has been strong demand for industrial metals. And any traction on the Biden administration’s clean energy and infrastructure initiatives could sustain the boom for industrial metals and materials—though tougher regulations are a risk. And demand for chemicals (the largest industry in the sector) may continue to increase as oil demand improves—but oil rig counts have been slow to rise. Significant supply chain bottlenecks are a concern, and strong performance has eroded valuations. Finally, the run-up in industrial and agricultural commodity prices may have run its course.

Positives for the sector:

  • Optimism for an improving economy and weakening trend in the U.S. dollar;
  • Improving global economic growth is supporting chemical demand and pricing power;
  • Strong gold demand is supporting precious metals mining;
  • Strong relative momentum;
  • U.S. clean energy and infrastructure spending could spur demand for industrial materials. 

Negatives for the sector:

  • The slow recovery in the oil rig count is a headwind for oil-fracking chemicals—though demand for oil is improving.
  • Valuations have been eroded by strong recent performance.

Risks for the sector:

  • A pickup in global COVID-19 cases;
  • Potential stringent environmental regulations;
  • Reversal of the 2017 corporate tax cuts.

 

Real Estate: Marketperform

 

 

The Real Estate sector includes equity real estate investment trusts (REITs) that invest primarily in commercial properties (e.g., office buildings, retail centers, apartment buildings), and companies engaged in real estate development and operation, such as real estate agents, brokers and appraisers.

The COVID-19 pandemic continues to be a source of uncertainty for the Real Estate sector, but mass-vaccinations, declining new COVID cases and relaxed restrictions on public gatherings may be starting to reduce investor pessimism. Fiscal relief packages have staved off massive retail lease defaults, but elevated residential delinquencies still pose risks—particularly as the eviction moratorium may not be extended amid legal challenges and unemployment remains high. The outlook for office REITs is highly uncertain and will likely stay so until we know if there will be an enduring shift toward remote working—though the recent trend appears to be for most workers to eventually return to the office. While net debt for the sector is low by historical standards, the risk to cash flow puts many REITs in a difficult position.

There are some exceptions, however. Warehouse/distribution center demand appears to be outstripping supply—resulting in sharply rising rents. And with the rapid rise in home prices amid low rates and de-urbanization, REITs specializing in single-family home rentals and manufactured homes stand to benefit—and this will likely translate into higher multi-family rents, as well. If the economy expansion continues at a brisk pace, people get back to work, and interest rates stay low as the Federal Reserve maintains accommodative monetary policy, the Real Estate sector could do very well. In a generally still low interest rate environment combined with renewed demand for office and retail space, investors’ search for yield and attractive valuations could be a strong tailwind for the sector. However, this would have to overcome the traditionally defensive characteristics of the sector.

Positives for the sector:

  • Optimism for improving economic growth and vaccine distribution;
  • Fiscal stimulus is a lifeline for those behind on apartment and retail space rent;
  • Low interest rates are positive for funding and make REITs dividends more attractive to investors;
  • Warehouse, data center and telecom towers are benefiting from technology and e-commerce trends.
  • Single-family residential REITs segments are seeing strong demand and rising rents, which will likely translate into higher multi-family rents.
  • Valuations are still relatively attractive.
  • Long-term demographics support recovery in extended-care and assisted-living facilities.

Negatives for the sector:

  • High unemployment can lead to multi-family lease defaults.
  • A sharp turn higher in home-ownership rates and de-urbanization is a negative for multi-family housing.
  • An accelerated shift to internet from brick-and-mortar stores puts retail REIT revenues at risk.
  • Short-term uncertainty exists about workers returning to the office;
  • Traditionally defensive characteristics in a rising market.

Risks for the sector:

  • A quicker-than-expected rise in interest rates could be a sharp headwind.
  • A permanent rise in work-from-home could reduce demand for office real estate.

 

Utilities: Underperform

 

The Utilities sector includes electric, gas and water utilities; independent power producers and energy traders; and companies that produce electricity using renewable sources (e.g., solar, wind, hydropower).

The Utilities sector has tended to perform relatively better when concerns about slowing economic growth resurface, and to underperform when those worries fade. That’s partly because of the sector’s traditional defensive nature and steady revenues—people need water, gas and electric services during all phases of the business cycle. Meanwhile, the low interest rates that typically come with a weak economy provide cheap funding for the large capital expenditures required in this industry.

However, while interest rates are low from a historical perspective, they have ramped higher as the economy continues to expand and stimulus is raising inflation expectations. On the flip side, there is the potential for a renewed decline in the economy to push rates even lower, or there could be significant government funding to Utilities as part of clean-energy initiatives that would benefit the sector’s profit outlook.

Positives for the sector:

  • Generally stable revenues;
  • Investors often turn to utilities for dividend income when prevailing interest rates are low.
  • Low yields provide low funding costs for this capital-intensive sector.

Negatives for the sector:

  • Interest rates have begun to move higher.
  • Economic recovery makes the sector less attractive. relative to other sectors

Risks for the sector:

  • Uncertainty regarding potential clean-energy legislative funding; 
  • Much higher interest rates due to unexpected rise in inflation.

 

What do the ratings mean?

The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:

  • Outperform: likely to perform better than the S&P 500 index
  • Underperform: likely to perform worse than the S&P 500 index
  • Marketperform: likely to track the S&P 500 index

 

Our view on individual sectors

Schwab Sector Views can be useful in identifying stocks by sector for potential purchase or sale. Schwab clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations. When it's time to make adjustments, clients can use the Stock Screener or Mutual Fund Screener to help identify buy or sell candidates in particular sectors. Schwab Equity Ratings also can provide a fact-based and powerful approach for helping you select and monitor stocks in each sector.

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