Materials: Underperform
After a few months of good performance, we believe the materials sector may be in for a period of underperformance, and are adjusting our rating to reflect that belief. The sector has benefitted from continued robust growth in China, and while we believe the country’s economy will continue to expand, China’s recent interest-rate hike leads us to think more-moderate growth may be in store. This could lead to some profit taking in the group.
Additionally, the multi-month trend of dollar weakness has certainly helped boost performance of the materials sector. While we don’t necessarily believe that a long-term reversal is in store, we think that at least some short-term strengthening is in order. With weakness in the dollar largely coming in anticipation of the potential for more Fed action in the United States, we believe a typical “buy the rumor, sell the news” scenario may be in store. This would lead to the dollar strengthening in the near term, which would likely hurt profitability in the materials group.
Finally, inside the sector, we’ve seen wage costs increase, while pricing power appears to be eroding. This combination is not overly positive for profit margins and helps solidify our decision to reduce the rating on the group to underperform.
Clients can see our top-rated stocks in the materials sector.
Positive factors for the materials sector:
- Scrap steel prices have started to rise.
- Several central banks are talking about a renewed round of stimulus, which would be reflationary in nature—typically adding to demand for materials goods.
Negative factors for the materials sector:
- Chinese demand for processed commodities might be slowing as technological advances and a build-out of production facilities allow the country to produce more of its own materials. China recently transitioned from a net importer to a net exporter of steel.
- Global steel production is growing and Chinese steel inventories have spiked, both of which could pressure prices in the near future.
- Several key chemical prices are declining, indicating that demand is softening.
- Some central banks are reining in stimulus measures.
- Several governments are implementing austerity measures, which could crimp demand for materials.
- Wage costs are rising in the materials sector.
Telecommunications: Marketperform
The telecommunications sector looks a bit more attractive as investors seek out higher-yielding areas of the market to help offset the low interest rates on many fixed-income investments.
Although the sector lagged to start the year, we maintained our marketperform rating on the group in anticipation of just the sort of action we've seen of late. The telecom sector has lost some of its traditional defensive appeal, in our opinion. The group has moved much of its business model from the stable, regulated fixed-line business to the more-variable, consumer-dependent wireless arena, while also dealing with an onslaught of competition from a variety of sources. However, many still view telecom as more defensive, seeing the remaining fixed-line business as a cushion against variable revenues in less-certain times.
Competition for increasingly budget-conscious consumers remains fierce, and telecom certainly hasn't been immune to bargain-hunting shoppers. We're watching developments in this area especially closely given that new products still seem to be enticing consumers to spend, but we wonder how many times the sector can draw from that well.
In contrast to the technology sector, companies in the telecom sector have a lot of debt on their balance sheets, so we continue to view the group with caution. However, we are seeing credit markets loosen slightly, which might allow the sector to roll over that debt and continue to invest in their businesses.
Clients can see our top-rated stocks in the telecommunications sector.
Positive factors for the telecommunications sector:
- Wireless demand appears to be increasing as more communication and media devices move to the wireless arena, although some of that movement is likely to take away from fixed-line revenue.
- The higher dividends typically paid by telecom companies are increasingly attracting investors tired of paltry fixed-income yields.
Negative factors for the telecommunications sector:
- Consumer spending on telecom compared to total spending is now falling, which has typically coincided with underperformance for the sector.
- Net profit margins are declining for the telecom sector as competition squeezes margins.
- The telecom sector has the highest debt-to-equity ratio of any nonfinancial sector. That could hurt the group in this time of tight credit.
Utilities: Marketperform
Similar to the telecom sector, we're certainly not in love with the utilities sector and recognize the numerous issues it faces. However, the group is starting to be more attractive as investors search for areas of the market that pay a bit more in dividends, given their disenchantment with the low yields on fixed-income investments. As a result, we are holding our rating on utilities at marketperform.
Encouragement for the sector also comes from developments in Washington. It appears that many of the onerous and costly environmental regulations under discussion are on hold, at least for the near future. This helps provide a measure of certainty to the sector.
All is certainly not perfect with the sector. With housing still struggling, the demand for utilities continues to be relatively weak, which would seem to limit growth—although a glimmer of hope is emerging with electricity production starting to grow again.
We believe there are just enough positives for the utilities sector to warrant a marketperform rating—for now.
Clients can see our top-rated stocks in the utilities sector.
Positive factors for the utilities sector:
- Dividend-paying stocks remain attractive as long as yields on conservative fixed-income products remain relatively low. And should economic prospects decline more than currently expected, defensive, dividend-paying stocks could become even more attractive.
Negative factors for the utilities sector:
- Utilization rates of electric and gas utilities have moved down modestly while production has spiked, indicating a potential oversupply issue that could pressure margins.
- Electricity prices have weakened as a result of dampened demand during the global recession.
- Likely tax increases on dividends could affect the attractiveness of this higher-yielding group.
- Capacity growth has been rising, which has been a sign of underperformance for the sector in the past.
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