The expectation of inflation to rise in the near future is looking to turn into a reality. The rising US yield may be an indication of the hike in interest rates in the days to come. What remains a silver lining for the investors is the robust growth witnessed in the corporate earnings in the recent earnings season. However, inflation and interest rate making their impact from now on will make investors re-look at the sectors and stocks, giving way to sector-rotation in a big way. As a long-term investor, unless better clarity emerges on the sector front, it’s always better to be diversified across the broad economy and take exposure through index-based ETFs.
David Kastner, Director, Senior Investment Strategist, Schwab Center for Financial Research takes a three- to six-month outlook for stock sectors, which represent broad sectors of the economy. In his report Kastner says, “Signs are growing that inflation may be more tenacious than originally expected. We don’t believe a return to 1970s-style inflation is likely, but there is a worrisome scenario in which persistently sharp increases in prices could be a factor to reckon with— and if history is any guide, they could have an impact on sector performance.” Kastner goes on to talk about the sectors that will be positively and negatively impacted by inflation. Excerpts:
When inflation is stubbornly high, sectors such as Energy, Real Estate, Health Care, Utilities, and Consumer Staples historically have outperformed on average. Others such as Consumer Discretionary, Industrials, Materials and Financials have struggled in general.
The lopsided impact of the COVID-19 pandemic could alter some historical patterns. For example, Information Technology historically has struggled when inflation was high and rising. However, technology has become so integral to daily life and the overall economy—more so during the pandemic, when working remotely, shopping online, and streaming entertainment became ubiquitous—that the sector may react differently to high inflation going forward.
To be clear, we don’t think that we are currently in the more dire inflationary scenario, but the market might periodically reflect investors’ worries that we are going down that path—so let’s take a look at how various sectors might perform, and why.
Sectors that may benefit from higher inflation
1. Energy: In the early stages of an inflationary cycle, Energy typically benefits from the same factor that drives overall prices higher: demand that outstrips supply. Historically, the Energy sector has often been one of the top relative performers when inflation is on the rise—at least until the Federal Reserve tightens monetary policy enough to slow economic growth, or excess supply causes prices to drop.
2. Real Estate: Rising inflation usually reflects an improving economy, which tends to be good for the real estate investment trusts (REITs) that make up the bulk of the Real Estate sector. Office buildings and retail shopping centers experience greater demand for space and can charge higher rents when economic growth is strong.
It’s true that the rising interest rates that typically occur with inflation can be a headwind for the Real Estate sector, which relies heavily on borrowing. However, commercial real estate prices also tend to rise, providing a positive counterbalance—this is particularly true when the rate of inflation is high relative to interest rates (i.e., when “real,” or inflation-adjusted, interest rates are low) and the economy is growing, as is the case now.
3. Traditionally defensive sectors—Health Care, Utilities and Consumer Staples: These sectors tend to outperform during periods of high inflation. In part, this is due to their relatively steady earnings no matter the economic conditions—people need medicine, heat, and food in any economy—and their ability to pass higher costs on to consumers.
Sectors that may struggle amid higher inflation
1. Consumer Discretionary: This sector, which includes business lines ranging from apparel and automobiles to home improvement and internet retailers, is a favorite punching bag when it comes to inflation—and rightfully so.
As the script goes, higher energy costs and reduced purchasing power due to higher prices in general eat away at nonessential consumer spending, especially for lower-income consumers.
However, there are currently some mitigating circumstances. Unlike past eras, energy on average accounts for only about 4% of disposable income—half of the level in the early 1980s—so price increases may not have a significant impact. And wages are rising fast—particularly for the lower-paid service workers in the leisure & hospitality and retail industries—taking the sting out of higher overall inflation. Additionally, household finances are relatively healthy, and banks are eager to lend at attractive interest rates.
In terms of fundamentals for businesses in the sector, supply constraints are affecting sales and production, with the auto industry being one of the hardest-hit by the semiconductor shortage. Meanwhile, many companies within the Consumer Discretionary sector are facing higher costs—in large part due to surging shipping costs, wholesale prices, and wages.
So far, many are having some success in passing along higher costs to consumers amid strong demand, thereby protecting profit margins. However, if the economy slows, the Fed tightens monetary policy because of mounting inflation concerns, and/or market volatility picks up, this cyclical sector could underperform, as it has historically done during periods of higher inflation.
2. Financials: The sector’s initially positive reaction to higher prices and accompanying rise in interest rates tends to fade when inflation rises sharply. At first, the growing economy behind rising inflation is good for banks and other Financials industries, as it spurs loan demand and lowers credit defaults.
This can be true even as the Fed begins to intervene to slow inflation by raising short-term interest rates. However, the picture changes if inflation continues to rise at a fast pace and the Fed’s policy becomes much more restrictive to counteract it.
In the simplest terms, banks borrow at short-term rates (the rates they pay depositors) and lend at longer-term rates. When the Fed raises short-term rates aggressively, it typically leads to expectations for slower economic growth that can drive long-term rates lower, resulting in lower net interest margins and potentially weaker relative performance for Financials. Stronger-than-usual balance sheets currently could mitigate the headwinds if a more dire scenario were to play out, but likely not enough to thwart underperformance.
3. Industrials: Relative performance of this sector historically has been weak during periods of high and rising inflation. Companies typically face challenges from higher input costs along with ebbing demand for cyclical products such as construction equipment and industrial machinery.
Current supply constraints, high labor costs, and the spike in fuel costs are all headwinds for the sector, particularly for heavy fuel users and labor-intensive industries such as airlines, package delivery, and transport industries. On the plus side, inventory rebuilding and the backlog of product deliveries could benefit the sector once supply bottlenecks have cleared.
4. Materials: Although the Materials sector typically gets support early in an inflationary cycle as global growth and demand remain strong, concerns about slowing economic growth can take a toll. The recent slowdown in Chinese growth could mean that Materials stocks would struggle even earlier and to a greater degree than usual.