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Q2 2021 sector scorecard

The financials and energy sectors may be areas to watch as inflation returns.

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Key takeaways

  • Cyclical sectors benefited in the first quarter thanks to the rebounding economy: Energy, financials, and industrials led the market.
  • Going forward, the financials and energy sectors look attractive due to cheap valuations, relative strength, and the improving economic outlook.
  • The financials sector may be in a particularly good spot due to rising inflation, increasing inflation expectations, and the recovering economy.
  • Income is up for US consumers—and that may spur some inflation but stock valuations may hold up since there has been a positive correlation between stock prices and income growth since 2005.
  • The Fed is likely to keep interest rates low and that may help boost stocks if inflation increases.

The post-recession rotation into cyclical sectors continued in the first quarter of the year with optimistic investors piling into energy, financials, and the industrials sectors. Defensive sectors and tech lagged but showed positive returns. For the future, Fidelity's sector strategist, Denise Chisholm, is bullish on the financials and energy sectors. Find out why and what else to watch for in the second quarter.

View the interactive chart presentation.

Performance summary: Rotation into cyclicals continues

The rotation into cyclical stocks continued into the first quarter of 2021. Cyclical sectors expected to rebound with the economy led by wide margins during the first 3 months of the year, as investors favored them over technology and defensive sectors. Energy, financials, and industrials led the market. Consumer staples, technology, and utilities lagged but still posted positive returns for the quarter.

Scorecard: Bullish on financials and energy

Cheap valuations, relative strength, and the prospect of a continued economic recovery contribute to a constructive outlook for the financials and energy sectors. Conditions may be less favorable for sectors with more defensive characteristics, including utilities and communication services, which have historically been less likely to benefit from economic recovery. Real estate may also face headwinds in the form of high valuations and challenged fundamentals.

Fundamentals: Strength in tech, staples, and health care

As of the end of Q1, the technology sector leads the fundamental rankings, with market-topping positions in EBITDA growth, return on equity, and free-cash-flow margin as well as a second-place finish in EPS growth. Consumer staples and health care also screen well. In contrast, energy ranks last on three of our fundamental measures and second-to-last on the fourth. Real estate and industrials also appear challenged from a fundamental perspective.

Valuations: Financials, energy, staples look cheap

As of the end of March, financials stocks have the cheapest valuations for the third quarter in a row. Financials' price-to-book and price-to-earnings ratios rank second and third, respectively, and both are at the very low end of their historical ranges. Energy and consumer staples also look relatively cheap. Consumer discretionary, industrials, and real estate valuations appear the most elevated.

Relative strength: Energy, financials, and industrials on top

The energy, financials, and industrials sectors exhibited the greatest relative strength over the past 6 months, as they benefited from investors' rotation into cyclical stocks. A move away from defensive stocks helped relegate utilities to last place in our relative strength rankings, followed by consumer staples and health care.

US incomes recently hit post-recession highs

The influx of cash from pandemic relief programs has jolted consumer incomes, and this recent rise in real (inflation-adjusted) incomes has been more persistent than at any time since the late 1990s. Income growth, which includes wages, transfers, and stimulus checks, is almost eight times higher than the average 12 months after recessionary troughs since 1960. Although income growth has come off record levels, it clearly remains in the highest quartile of its 50-year range.

Inflation may be on the way, but it may not hurt stock valuations

If history is a guide, top-quartile consumer real income growth may suggest higher inflation—but it may not mean equity valuations will suffer. Starting in 2005, the long-term correlation between income growth and stock valuations flipped from negative to positive. Since then, stock valuations have been more likely to rise than fall when income growth has been in its top historical quartile. Cyclicals fared better than defensives amid high income growth over the same period.

Inflation expectations suggest a market advance

Over the last 20 years, inflation expectations have risen faster than inflation itself about one-third of the time. That's the case now and it may continue as we exit recession. During that span, stocks advanced in 95% of all rolling 12-month periods in which inflation expectations grew faster than inflation. The market's return in those periods was more than three times its return the rest of the time.

Negative real rates may be constructive for stocks

The Federal Reserve has signaled its reluctance to raise interest rates, which could hold down nominal rates across the yield curve. Meanwhile, inflation looks likely to increase. This combination could keep real long-term interest rates negative for some time. Environments with both accelerating inflation and negative real interest rates have been rare. But when they've occurred, the equity market has fared well, advancing in 88% of those episodes.

The inflation breakpoint

Investors worry that rising inflation could boost bond yields and that higher bond yields could weigh on equities. How high would yields have to be to pose a problem for the stock market? Historically, the breakpoint has been a real yield of 2% on the 10-year Treasury. The 2% inflection point has held since 1948 and since the global financial crisis. Real yields are negative now, so they may have room to rise before dragging down equities.

Opportunities in financials

In the past, financials tended to outperform when their fundamentals improved. But that has not been the case since the global financial crisis. The analysis below shows that even if investors had precisely timed when financials' fundamentals would improve, since 2009, the sector would likely still have underperformed over the next year. Rather, financials' periods of outperformance came when their valuations expanded.

Financials' valuations historically have been tied to rates

What drives financials' relative valuation? Historically, it's been the level of interest rates. The steady decline in interest rates from cycle to cycle since 1970 has corresponded with a long downward trend in financials sector valuations relative to the broad market. If inflation leads to higher rates over time, financials stocks' relative valuation multiples may increase, and the sector could outperform.

A sweet spot for financials?

Inflation appears likely to rise above 2%, and inflation expectations could keep increasing. Meanwhile, the economy is emerging from recession. That combination—inflation above 2% and inflation expectations rising—has been the financials sector's sweet spot (outside of the global financial crisis.) Under these circumstances, financials have outpaced the market 81% of the time, outperforming by an average of 3 percentage points.

Financials' run could continue

S&P 500 financials stocks gained approximately 40% in the 6 months through March, outperforming the S&P 500 by more than 20 percentage points. Have investors missed the bounce in financials? Maybe not. When the sector has outperformed over a 6-month period historically, it has continued to do so over the next 6 months more than two-thirds of the time, outside recessions. The sector has had 85% historical odds of outperformance after beating the market by more than 15%.

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