Schwab Sector Views: Neutral on Consumer Staples
In last month’s Schwab Sector Views article, “Too Early for Defensive Positioning,” we highlighted plenty of things to worry about:
- the rise in the COVID-19 delta variant;
- concerns that the Federal Reserve might pull back on easy monetary policy sooner than expected if inflation doesn’t turn out to be transitory;
- ongoing shipping backlogs and parts shortages;
- and the fading impact from fiscal stimulus.
All of these could slow future growth. However, we noted that while we may have seen a peak in the rate of economic growth—which has resulted in a choppy rotation of sector leadership in recent months—we said it was premature to anticipate a peak in the level of growth. We didn’t expect defensive stocks in general to persistently outperform in the coming months.
That remains the case. However, we are now making an incremental change to our sector views—moving Consumer Staples to “marketperform” from “underperform”—in recognition of some developments that could alter economic and market conditions, as well as some factors related to the Consumer Staples sector, which includes food, beverages, detergent, shampoo and supermarkets.
Economic and market developments
There continue to be signs that the pace of economic growth is moderating (though continuing), inflation may be less transitory than thought, and the Fed has signaled its intention to start unwinding accommodative monetary policy as soon as the end of this year or in early 2022. Fortunately, new COVID-19 delta variant cases appear to have peaked in the U.S., although the spike slowed the recovery in several industries.
The recent inflation report show some slowing in the three-month annualized rate of consumer inflation (see the chart below). However, it is becoming clearer that inflation likely will be more persistent than previously thought, as shipping backlogs and parts shortages appear likely to continue into next year. This has resulted in some industries reducing production—with the automotive industry being a high-profile example, due to semiconductor shortages. Additionally, the pace of improvement in the labor market has slowed, as businesses find it increasingly difficult to hire qualified workers, forcing wages higher and slowing business activity in some areas of the economy.
The pace of inflation and economic growth is high, but slowing
Source: Charles Schwab, Bloomberg as of 9/23/2021. Purchasing Managers’ Index™ (PMI™) data are compiled by IHS Markit for more than 40 economies worldwide. The monthly data are derived from surveys of senior executives at private sector companies and are available only via subscription. The PMI dataset features a headline number, which indicates the overall health of an economy, and sub-indices, which provide insights into other key economic drivers such as GDP, inflation, exports, capacity utilization, employment and inventories.
As the chart above shows, the Markit PMI—a proxy of current business conditions—has declined but remains above 50, denoting ongoing growth. Small-business managers are generally optimistic, but see future business conditions more challenging, according to the National Federation of Independent Business. Meanwhile, the Federal Reserve’s Federal Open Market Committee released its latest quarterly updated forecasts on September 22nd, noting that it had downgraded its near-term economic growth outlook and increased inflation expectations. However, it remains relatively upbeat and slightly more hawkish, saying “if progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted.” It’s now anticipated that the Fed will announce plans to start tapering late this year or early in 2022, and likely raise rates after it completes tapering its bond-purchases later in 2022
The Fed’s latest dot plot suggests initial rate hike in 2022
Source: Bloomberg. FOMC dot plot as of 9/22/2021. Each dot represents the view of a Fed policy maker for the rate’s target range at the end of each year shown. Nine of the 18 members project rates to rise in 2022, and the majority of members project at least three 0.25% rate hikes by the end of 2023.
Other developments and potential market impact
Chinese policymakers have continued to ratchet up a crackdown on Chinese technology firms, China’s real estate giant Evergrande is facing collapse, and the U.S. debt ceiling is fast approaching with little agreement in Congress on how to deal with it.
While there is likely to be little direct impact on the U.S. economy from the events in China, Fed Chairman Jerome Powell said in the FOMC’s post-meeting press conference that a disorderly collapse of Evergrande and knock-on effects throughout the Chinese economy could have a negative impact on global financial conditions. Though we think a U.S. federal debt default is very unlikely, Powell stressed the dire consequences of Congress not raising the debt ceiling and the limited ability of the Fed to stem any severe fallout. As of this writing, it’s not yet clear if these issues will affect the U.S. stock market in a lasting way. However, with the combination of these developments and the less-certain economic environment, it is clear that risks have risen—and the slowing momentum in cyclical stocks (which tend to perform better when the economy is growing) versus defensive stocks (which tend to outperform when the economy is slowing) may be reflecting this.
Cyclical vs defensive momentum has slowed
Source: Charles Schwab, Bloomberg as of 9/23/2021. The Barclays Cyclical/Defensive Pair Index (Bloomberg BCSUCYCF Index) is the equivalent of a pair trade involving being “long” the US Large Cap Cyclicals basket (BCSUCYCL Index), and “short” the US Large Cap Defensives basket (BCSUDEFS Index). An investor with a long position has bought and owns the securities; an investor with a short position owes the securities but does not actually own them yet. Arrow reflects general trend in ISM data. Momentum measures the rate of the rise or fall in stock prices, with a reading below zero in this chart indicating negative momentum of cyclical versus defensive stocks. Past performance is no guarantee of future results.
Why we’re raising our rating on Consumer Staples to Marketperform
Currently, we think interest rates are going to rise as the Fed unwinds its accommodative policy, the economy continues to grow, and inflation remains somewhat tenacious. Based on the Consumer Staples sector’s traditional sensitivity to changes in interest rates, this would be a headwind to the sector relative to many other sectors. However, slowing economic growth—and associated potential for higher market volatility—could weigh on cyclical sectors, such as Materials and Industrials, boosting the relative attractiveness of the more defensive and larger-cap stocks within the Consumer Staples sector. On balance, we think the macroeconomic impact on the sector is neutral relative to the other sectors, as illustrated by the “0” in the Sector Overview table below.
Source: Schwab Center for Financial Research, as of 09/23/2021. 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 09/23/2021. 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.
Many of sector’s valuations measures are still above their historical averages, as is the case for nearly all the other sectors. But in relative terms, Consumer Staples falls in the middle of the pack, although slower economic growth could weigh on valuations for many of the cyclical sectors—potentially moving Consumer Staples up in rank. To be sure, the ongoing rise in transportation and commodity costs have weighed on earnings, but many of the companies in the Consumer Staples sector have been able to pass some of those higher costs on to consumers. And the reopening of restaurants is boosting wholesale food demand, which portends an improvement in fundamentals—particularly if companies can maintain prices at higher levels as input costs presumably ease in the coming months. Yet, it has not yet been seen if pricing power can be maintained amid stiff competition within the sector. For now, this leaves the fundamental rank of the sector at neutral, as well. Finally, the relative performance of the sector has been one of the worst since the market lows in March 2020. However, as shown the momentum chart above, this could change as the negative price momentum of defensive shares compared to those in cyclical sectors has slowed considerably in recent months.
As the host of neutral readings in the Sector Overview table implies, we don’t think the Consumer Staples sector is poised to persistently outperform in the near term—but as the economy transitions toward slower growth, we don’t expect it to continue to underperform, either. In the context of our neutral view on equities overall, we see the potential for sporadic rotation of sector leadership among cyclical and defensive sectors amid periods of higher volatility. We’re monitoring for opportunities in the other sectors, but the current environment is making it very difficult to make many high-conviction calls.
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 broader stock market*
- Underperform: likely to perform worse than the broader stock market
- Marketperform: likely to track the broader stock market
* As represented by the S&P 500 index
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How should I use Schwab Sector Views?
Investors should generally be well-diversified across all stock market sectors. You can use the Standard & Poor's 500® Index allocations to each sector, listed in the chart above, as a guideline.
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What You Can Do Next
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