There’s a solid chance that the rate of inflation will keep declining, which means so-called cyclical stocks could pop.
Cyclical companies are those that see the largest fluctuations in sales and profits when the economy strengthens or weakens. On the list are materials producers such as steel makers and copper miners, which enjoy better demand from manufacturers when the public has more money to spend. Restaurants and consumer goods companies benefit for the same reasons.
Banks lend more and complete more transactions when demand improves. And investment-management companies gain when rising market boost assets under management because their fees depend on how much money they oversee. Industrials tend to gain too, but they have less room to rise following recent gains.
Inflation makes a difference to these companies in two ways. When prices are just starting to take off, it can be a positive signal that demand is picking up. Higher prices boost revenue as long as sales volume doesn’t fall too much.
The problem is later in the economic cycle, when inflation is high enough to prompt the Federal Reserve to raise interest rates to cut into demand for goods and services, as it began to do in early 2022. At that point, investors want inflation to come back down so that rates can be reduced, encouraging consumption and allowing the economy to keep growing.
That is why cyclical stocks will pop if the consumer price index for February, to be released next month, comes in lower than expected.
While some economists haven’t released forecasts for the gain in February’s CPI, there is plenty of evidence that inflation will continue to moderate. The CPI rose 3.1% in January, down from a peak of just over 9% in 2022, as the Fed looks to move it down toward its 2% target.
Aiding that process is the fact that the cost of services, which drove much of January’s unexpectedly high CPI result, often moderates after the first month of the year, as it did in 2023, 22V Research’s Dennis DeBusschere noted. The closer to CPI moves to 2%, the more likely the Fed is to cut rates to support economic growth.
Highlighting the link between inflation and cyclical stocks is that the group suffered after this week’s hotter-than-expected CPI data. The Materials Select Sector SPDR Fund dropped 1.4% Tuesday, the day of the report, while the SPDR S&P Metals & Mining exchange-traded fund declined 3.9%. The Financial Select Sector SPDR Fund fell 1.3% and Consumer Discretionary Select Sector SPDR Fund dipped 2%.
A favorable inflation result likely would have the opposite effect. It appears that lower-than-expected inflation “helps the case for cyclicals and risk-on factors through 2024,” wrote DeBusschere.
Adding to the appeal is that those names are still trading at reasonable valuations. The materials ETF trades at just over 19 times the aggregate per-share earnings analysts expect from companies in the fund to produce over the coming year, below the
S&P 500
at just over 20 times. It often trades in line with the index when the outlook for demand for steel and other materials improves.
The metals and mining ETF trades at just under 15 times earnings, well below the S&P 500. That discount has been wider in the past 10 years, according to FactSet, but it still leaves room for the shares to run higher, especially since copper prices remain below their highs by double digits in percentage terms.
The financials ETF trades at 15 times earnings, a 25% discount to the S&P 500, while it has repeatedly traded closer to the market for prolonger periods in the past decade.
The consumer ETF, on an equal-weighted basis that excludes the outsize impact of Tesla and Amazon.com, trades at just over 15 times. It has traded in line with the market at times in the past few years. The lowest figure is a tad bellow 13 times.
All that adds up to a nice potential trade over the near term.
Write to Jacob Sonenshine at [email protected]
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