Chisholm: Top sectors to watch in Q2

Key takeaways

• Energy and utilities stocks were the main outperformers in the first quarter, as oil and gas prices rose and investors sought defensive plays.
• Looking ahead, a combination of low valuations and rising interest rates could give a boost to the financial sector.
• The consumer staples and health care sectors could also offer opportunity. Both look exceptionally cheap relative to their own histories.
• While many investors may be concerned about the impact of high inflation on markets, stocks have historically weathered inflationary periods well when the economy stays out of recession. Currently, the economy remains strong.

The first quarter this year saw some notable market shifts. Energy stocks experienced rapid price gains on rising oil and gas prices. And investors sought safety in defensive sectors amid rising market volatility, geopolitical tensions, and rising interest rates. But what sectors, factors, and themes could take leadership over the next few months? Fidelity's director of quantitative market strategy, Denise Chisholm, sees potentially favorable conditions ahead for the financial, health care, and consumer staples sectors.

Performance summary: The market gets defensive

Energy stocks led the market in the first quarter, as Russia's invasion of Ukraine sent oil and gas prices soaring. Defensive stocks also outperformed, with utilities and consumer staples coming in second and third, respectively, as the market declined. Communication services, consumer discretionary, and information technology were the bottom performers.

Scorecard: Favoring health care and financials

Low valuations in health care and financials have made those sectors appealing, while consumer discretionary's strong fundamentals may help the sector overcome high valuations. Energy and industrials also continue to look attractive. The utilities sector presents poor fundamentals and expensive valuations, earning it an underweight.

Fundamentals: Materials, discretionary, and tech lead

Materials led the fundamental rankings, coming in second in earnings-per-share growth and EBITDA growth. Consumer discretionary and information technology also scored well. Utilities were the worst-performing sector by fundamental measures, coming in ninth in earnings-per-share growth, EBITDA growth, and free-cash-flow margin. Real estate and consumer staples also posted relatively poor fundamentals.

Valuations: Financials, health care, materials look cheap

Financials continued to have the cheapest valuations at the end of the first quarter, ranking as the least expensive sector by price-to-earnings and price-to-book ratios. The most expensive sectors were consumer discretionary, utilities, and industrials.

Relative strength: Strength in energy, staples, and utilities

The energy, consumer staples, and utilities sectors exhibited the greatest relative strength over the past 6 months. Technology was weakest, followed by the consumer discretionary and communication services sectors.

Utilities on top in February, but perhaps not for long

Energy stocks have garnered a lot of attention, but in February utilities was the only sector with monthly returns in the 90th percentile of its historical range. In the past, powerful utilities rallies have signaled investors getting too defensive. The market typically has gained, and utilities have underperformed, in 12-month periods after top-decile monthly relative returns for the sector.

Rising rates may not be a problem

The Federal Reserve has begun hiking interest rates, trying to tamp down inflation that stems in part from rapid wage growth. That kind of scenario has worked out well for investors in the past. Historically, the market has been more likely to advance amid a tightening Fed and strong wage growth than when the Fed is accommodative and wage growth is weak.

This isn't the 1970s

Inflation is high and we are facing an energy supply shock. Are we heading into a replay of the energy crisis and bear market of the 1970s? It's unlikely. The US economy is far less dependent on energy imports than it was then, and stocks are much less expensive relative to bonds than they were 5 decades ago, so both look less vulnerable.

A strong economy trumps high inflation

In the past, the stock market has weathered high inflation well when the economy stays out of recession. Today, the economy is strong and healthy employment may bode well for future growth. I expect inflation to decline but stay above average levels. How far it falls will matter: Historically, annual inflation below 5% has corresponded with strong stock performance.

Global interest rates look bullish for financials

Financials have struggled with low interest rates in the US and negative rates around the world. Now yields are rising in the US and in Germany, and German bond yields have turned positive after languishing below zero for years. In the past, simultaneously positive and climbing yields in the US and Germany have been great news for financials, both domestically and in Europe.

Financials' valuations may position the sector to outperform

Financials also are very cheap relative to their own history. Bottom-decile valuations are uncommon, but when they've occurred, the sector historically has advanced 90% of the time over the following 12 months, outperforming the market by an average of 16%.

Consumer staples appear to be on sale

The consumer staples sector has been trading at an extreme discount to its own history, likely because its earnings growth has lagged far behind the market's in recent years. The combination of weak past earnings growth and rock-bottom valuations historically has been a buying opportunity.

Health care's setup looks similar

Like staples, health care has produced weak earnings growth relative to the market and sports a low valuation compared to its own history. Also like staples, the combination has tended to precede outperformance—and health care has the additional advantage of high and rising margins.

Low-volatility factor looks more appealing

The low-volatility factor has struggled over the last several years, as riskier fare has been relatively inexpensive. Now the relative valuations of high-risk stocks have risen, while low-vol factor valuations hover around their 50th percentile. Historically, the low-vol factor's odds of outperformance have improved when risk gets expensive, especially outside of recession.