Position for rates, reflation and reopening

Apr 21st, 2021 | By | Category: Equities

By Anqi Dong, Senior Research Strategist at State Street Global Advisors.

Position for rates, reflation and reopening

Position for rates, reflation and reopening

We have seen a noticeable shift in market sentiment as the vaccine rollout picks up speed and stimulus spending trickles into the economy. Rising inflation expectations and improving growth prospects have lifted 10-year yields to their highest level since 2015. Value stocks, which have historically shown a higher sensitivity to interest rates, have outperformed growth and high momentum stocks by a wide margin of late.

Meanwhile, elevated return dispersion and low correlation among sectors underscore a constructive environment to potentially generate alpha by using sector and industry exposures. Given this reflationary regime shift and favorable economic outlook, we see three industry opportunities that may benefit from the continued economic recovery.

Banks: Bright earnings prospects with attractive valuations

As higher long-term rates have driven the 10-and-2-year yield spread to its widest level since 2015, the bank industry outperformed the broad market by 18% in Q1. This is not surprising as, historically, bank stocks have shown a higher correlation to long-term rates than the broad market and the broader financial sector. Investors have taken advantage of banks’ rate sensitivity to position for a higher rate environment. As shown in the chart below, flows into bank-related ETFs picked up significantly following the increase in long-term rates in 2016 and have done so again recently.

Source: SSGA.

The case for investing in the bank industry becomes even stronger when considering the segment’s improving earnings prospects and attractive valuations. Despite the dire economic environment last year, banks have shown resilience during the pandemic. The industry posted its first positive earnings growth since the beginning of the pandemic, 7.8% in Q4, exceeding analyst expectations of negative growth of -17.3%. This positive earnings sentiment could continue into the coming quarters, as net interest income is likely to show further improvement on the back of the sharp steepening of the yield curve. As more people get vaccinated and economic reopening shifts into higher gear, business activities are likely to pick up, leading to more loan demand later this year. And as of right now, the industry is expected to post earnings growth of 38% in 2021, more than double the estimate of 16% at the start of the year.

Reserve releases may provide another tailwind for bank earnings. Banks built up their largest loan loss reserves since the financial crisis in the first two quarters of 2020 in anticipation of higher credit losses stemming from the pandemic. However, due to faster-than-expected vaccine developments and an improved economic outlook for 2021, banks started to release reserves in Q4, led by big banks. The recent Federal Reserve announcement of lifting restrictions on bank dividend and share buybacks on June 30th may further boost industry earnings and return of capital to shareholders in the second half of 2021. It is projected that major banks will repurchase $83 billion in stock this year, 6% of their market cap.

Despite strong performance over the past few months, bank stock prices may not fully reflect this improvement in earnings growth sentiment. The industry is currently trading at the 35th percentile over the past 15 years, based on 1-year forward price-to-earnings ratio. Its valuations relative to the broader market are even more attractive, trading within the bottom decile based on 1-year and 2-year forward price-to-earnings, as well as price-to-book ratios.

To position for rising rates and potentially improving profitability at inexpensive valuations, consider the SPDR S&P Bank ETF (KBE US).

Metals and mining: Strong metal demand and rising inflation

Global manufacturing activity is expanding at the fastest rate in more than a decade, creating robust demand for industrial metals this year. Although Chinese demand may grow slower than last year, given the government’s lower-than-expected growth and fiscal deficit targets for this year, strong demand driven by manufacturing recovery outside of China and the potential multi-year infrastructure plan in the US may support the industrial metal market further in the coming years.

While China manufacturing PMI is currently growing at its slowest level in the current 11-month period of expansion, eurozone and US manufacturing activity are expanding at their fastest pace on record. This bodes well with increasing demand for industrial metals globally. Additionally, President Biden’s infrastructure proposal of more than $2 trillion includes around $721 billion for transportation infrastructure, power grids and electric vehicles, and charging stations. Metals are indispensable materials for infrastructure, from traditional highways, bridges and ports to renewable infrastructure. President Biden’s emphasis on ‘Buy America’ provisions may create more demand for metals, benefiting domestic producers and miners the most. On the other hand, China — the largest producer of aluminum and steel — is accelerating capacity cuts in the mining sector to reduce pollution and achieve its environmental targets. With increasing demand chasing constrained supplies, the global metal prices rally that began last year is likely to continue, providing another tailwind for the industry.

Given strong demand and metal prices, metal producers and miners are expected to post earnings growth of 242% in 2021, up from 133% at the beginning of Q1 earnings season. Their growth estimate ranks highest among all GICS industries in the S&P Composite 1500 Index universe, exceeding the broad market by more than 200%. The industry’s strong growth prospects have not been fully priced in, indicating more upside potential for the industry. Even given its 20% gain in Q1, the industry’s forward price-to-earnings ratio is near the bottom quartile over the past 15 years. Compared to the broad market, its valuations are even more attractive, trading at the bottom 5th percentile over 15 years, based on the forward price-to-earnings ratio.

Furthermore, the industry has historically outperformed the broader market when inflation expectations moved higher, as shown in the chart below. To position for rising inflation expectations and strong metal demand, investors may consider the SPDR S&P Metals and Mining ETF (XME US).

Source: SSGA.

Retail: Economic reopening and consumer spending recovery

The US leads the world in total vaccines administered. It’s estimated that at the current rate of daily vaccinations, it will probably take another four months to have 75% of the population vaccinated. Reaching that 75% threshold would enable a “return to normal,” according to government officials. As a greater percentage of the population gets vaccinated, people may feel more comfortable visiting physical stores and gradually return to more normal shopping behaviors. While e-commerce has surged, online shopping is not the only way consumers want to experience products. Consumers still prefer to touch and feel the product before making a purchase for certain items.

After having out-of-home activities restricted for almost a year, consumers have shown a strong desire to venture out and start spending. According to McKinsey’s March consumer sentiment survey, more than 50% of US consumers expect to “spend extra by splurging or treating themselves” starting now and continuing post-pandemic, particularly on discretionary categories such as apparel, beauty and electronics. And with younger consumers showing even greater desire to spend extra, we are likely to see higher retail spending in the coming months as the younger population becomes eligible for the vaccine.

Some data have recently begun to show green shoots in brick-and-mortar retail. Prodco North America Retail Traffic Index, which is based on foot traffic data collected from sensors at retail stores, turned positive in March for the first time since 2019, as shown in the chart below. The Johnson Redbook Index showed that same store sales have increased for seven straight months on a year-over-year basis and the growth rate is at a record high.

The incoming $1,400 stimulus checks and elevated personal savings (as shown below) are likely to provide dry powder to fund pent-up demand as economic reopening accelerates. Stable recovery in the labor market may boost consumer confidence further to pre-pandemic levels, providing tailwinds for retail sales this year.

To position portfolios for economic reopening and recovery in consumer spending, investors may want to consider the SPDR S&P Retail ETF (XRT US).

Source: SSGA.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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