Schwab Sector Insights: A View on 11 Equity Sectors

by David Kastner, Senior Investment Strategist, Schwab Center For Financial Research

“Schwab Sector Insights: A View on 11 Equity Sectors” provides detail on our three- to six-month outlook for 11 stock sectors, which represent broad sectors of the economy. It is published on a monthly basis, and is designed for investors looking for tactical ideas. For more information on our current views, read the latest Schwab Sector Views.

Sector Overview

Source: Schwab Center for Financial Research, as of 11/9/2020. Sector weighting data is from S&P Dow Jones Indices, as of 10/30/2020. See "Important disclosures" for an explanation of the Macro, Value, Fundamental and Relative Strength factors. Past performance is no guarantee of future results.

Communication Services: Marketperform

The Communication Services sector includes telecommunication services providers, media (e.g., television, radio, print publications, advertising), entertainment (e.g., movie production, sports teams, streamed content), and interactive media (e.g., social networking websites, video games).

Pandemic-related stay-at-home behaviors have been good for some of the companies in the sector, as it has led to increased use of social media and demand for streaming entertainment. However, the shift from traditional TV and cable has dropped, hurting advertising revenues. Additionally, wireless service revenue growth is at risk if high unemployment persists. While the larger companies (Alphabet/Google and Facebook) enjoy significant competitive advantages due to their dominance in their respective business lines—search engine, social media and telecom— they also face emerging antitrust risks, as well as potential market saturation.

Longer term, we believe the rollout of fifth-generation (5G) cellular wireless technology could further increase demand within the sector, as 5G is expected to increase both speeds and growth potential. However, upgrading networks will require substantial capital investment, and the pandemic has slowed progress.

Positives for the sector:

• The competitive advantage for social media;
• 5G rollout should boost growth potential, but companies face near-term high capital expenditures;
• Social distancing has accelerated a shift toward streaming entertainment content.

Negatives for the sector:

• Antitrust regulatory trend is negative for the search engine and social media companies;
• Potential for increased social media regulation (for example, Section 230 legal shield under scrutiny);
• Streaming service market saturation;
• Valuations are difficult to assess.

Risks for the sector:

• Sector market capitalization is heavily concentrated in the top five stocks, whose movement can significantly influence the sector.

Consumer Discretionary: Marketperform

The Consumer Discretionary sector includes internet retailers, automobiles and parts, household durable goods (e.g., refrigerators, washers/dryers), consumer durable goods (e.g., televisions, home audio equipment), leisure products (e.g., sports equipment, bicycles, toys), apparel, luxury goods, footwear, casinos, hotels, fitness centers, restaurants and bars.

The Consumer Discretionary sector, as the name implies, includes companies that produce or sell non-essential products that consumers often do without when they are under financial stress or worried about job security. These industries within the sector tend to do best when the economy is growing and consumers feel confident about spending money. Low interest rates also tend to be a positive, as this encourages people to borrow and spend.

The sector has a number of industries with a high degree of exposure to COVID-19 business shutdowns and shelter-in-place orders—particularly the hotels and leisure and apparel industries—and these have been under sharp pressure. However, those industries are overshadowed by industries that have been boosted by COVID-19-related restrictions, such as home improvement stocks and the internet retail industry—Amazon in particular, which constitutes about 40% of the sector’s market cap. The ongoing trend away from brick-and-mortar retail business is likely to continue, but investor enthusiasm may have pushed valuations too high, despite the strong fundamentals in the sector heavyweights.

Positives for the sector:

• Online and home-improvement retailers benefit from social distancing;
• The shift away from brick-and-mortar is likely to continue to support online retailers;
• Economic recovery is positive for many of the more traditional discretionary industries.

Negatives for the sector:

• COVID-19 uncertainty likely to continue to weigh on travel and leisure activities;
• The sector is overly concentrated in internet retail;
• Valuations appear stretched.

Risks for the sector:

• Antitrust action is possible for the largest online retailer;
• Renewed weakness in the economy and/or stay-in-place orders likely would hurt traditional retailers.

Consumer Staples: Underperform

The Consumer Staples sector includes food, beverage and tobacco products; and food distributors (e.g., supermarkets, hypermarkets); non-durable household goods (e.g., detergent and diapers) and personal products (e.g., shampoo and cosmetics).

In recent months, pandemic-related social-distancing behaviors have bolstered grocery, big-box discount retailers, and household goods sales—although some of the food wholesalers that service restaurants have faced headwinds. Retailers within the sector have aggressively cut costs, leaving them in reasonable financial condition. But limited pricing power in a low interest rate environment gives them less–than-exciting top-line growth potential.

With additional fiscal stimulus, potential for a very effective vaccine now in late-stage trials, and accommodative monetary policies, we think that the economic recovery has a better chance of maintaining traction. At this stage of the business cycle, the consumer staples sector typically underperforms the overall market. While longer-term price momentum has held up, we think that growing confidence in the economy will weigh on relative performance going forward.

Positives for the sector:

• It typically has a stable earnings profile;
• Companies have engaged in aggressive cost-cutting;
• It has solid relative valuations.

Negatives for the sector:

• An improving economy and strong stock market historically typically make this defensive sector relatively less attractive to investors;
• Companies tend to have limited pricing power in a low-inflation environment.

Risks for the sector:

• Additional government fiscal stimulus and the future availability of a COVID-19 vaccine could further support the economy and reduce stay-at-home food and staples demand.

Energy: Marketperform

The Energy sector includes oil and gas drilling, equipment, exploration, refining, marketing, storage and transportation; and coal mining and production.

While the price of oil is well above recent lows, the Energy sector continues to face heightened uncertainty due to the supply/demand imbalance perpetuated by COVID-19-related economic shutdowns. This paints a challenging fundamental backdrop for the sector, given questions as to when the oil market will rebalance.
However, oil production was slashed quickly, putting less pressure on constrained storage capacity. Additionally, with relatively stronger balance sheets and access to cash, large energy companies are in a much better place than the entire oil patch, which is facing high insolvency risk. Nevertheless, even these companies are facing negative cash flow, which makes it increasingly likely that dividends could be cut. And an increasing onerous regulatory environment and clean energy initiatives may be a significant headwind to the sector.

Positives for the sector:

• Oil is priced near the level at which the average company can cover operating expenses;
• Supply has declined with lower production and OPEC compliance;
• Large diversified energy companies have strong balance sheets and access to capital.

Negatives for the sector:

• Oil demand is still down significantly;
• Dividends are at risk, losses are still mounting, and valuation are opaque;
• Weak long-term stock price momentum;

Risks to the sector:

• New or expanded regulations could inhibit company growth potential
• OPEC may not renew the current supply agreement in 2021;
• Clean-energy initiatives eventually may dampen demand for oil.

Financials: Outperform

The Financials sector includes banks, savings and loans, insurers, investment banking, brokerages, mortgage finance companies and mortgage real estate investment trusts.

In general, we believe that the Federal Reserve has much more influence on the economy and markets than the politicians in Washington. Another split Congress would dampen expectations for a large fiscal spending package. However, a moderate fiscal stimulus combined with a Fed that is likely to be very cautious about raising rates AND the potential for very effective vaccine could push longer-term interest rates higher—augmenting solid fundamentals in the Financials sector.

Banks’ balance sheets came into the pandemic crisis relatively strong, thanks in part to stringent regulations put in place since the financial crisis of 2008. The recent stress tests conducted by the Federal Reserve confirmed this. Under the most rigorous scenario—a W-shaped double-dip recession—banks’ aggregate capital reduction would leave them with still-adequate capital ratios. Fiscal and monetary stimulus measures—which have contributed to the recovery—should soften the expected wave of bankruptcies and defaults.

The Fed’s commitment to keep short-term interest rates low likely opens the possibility for the yield curve (the difference between short-term and long-term interest rates) to steepen, which would help net interest margin revenues. Investors have remained focused on the interest rate headwinds—resulting in poor stock price momentum. However, the steepening of the yield curve recently—amid rising expectations for a successful vaccine—has reversed some of that. The sector tends to outperform in the early expansion phase of the business cycle, and we think that quite attractive valuations and strong financial positions are enough to lead to outperformance. Risks would include: the surge in COVID infections could result in renewed stay-at-home orders—stalling the economic recovery—or there could be significant increase in regulations on the sector under the new administration. But stacking up the positives, negatives and risks, we think that the sector is more likely to outperform the overall market in the coming months.

Positives for the sector:

• Strong financial position due to stringent post-2008 regulations;
• Economic recovery and fiscal stimulus are tailwinds for loan demand, and likely will limit defaults;
• Cautious Fed along with improving growth prospects has started to steepen the yield curve;
• The sector has attractive valuations relative to its historical average and other sectors;

Negatives for the sector:

• Despite long-term interest rates trending higher, rates in general are expected to remain very low;
• Rising loan defaults are inevitable, but banks have set aside large loss reserves;
• Longer-term price momentum has been weak, though it has improved recently.

Risks for the sector:

• A stalled recovery, or renewed economic shutdown due to spike in COVID-19 cases;
• Not enough fiscal stimulus needed to foster a continued recovery;
• Increased banking regulations.

Health Care: Outperform

The Health Care sector includes hospitals, nursing homes, health care equipment and supplies, health care services (e.g., dialysis centers, lab testing) managed-care plans (e.g., health maintenance organizations, or HMOs), health care technology, pharmaceutical, biotechnology and life sciences companies.

We recently initiated an outperform rating for the Health Care sector. Heading into the 2020 election, the Democratic Party’s health care proposal seemed to be major source of the angst. Biden’s proposed “public option”—a more affordable, or free, alternative to private health insurance—and enhancements to the Affordable Care Act (ACA) raised questions about the sustainability of profit growth in the health care sector.
However, following the 2020 general election, the Democrats will be left with either a split congress or a very narrow margin—which will be determined by the results of the January 5th Senate run-off election in Georgia. If Congress is split, few if any parts of the “Bidencare” plan are likely to be implemented, reducing a major source of uncertainty. Even in the Democrats’ best-case scenario—a 50/50 split, with projected Vice President-elect Kamala Harris as the tie-breaking vote—the party would have a razor-thin majority, and division between progressive and moderate Democrats could very well result in many of the more contentious health-care initiatives being much tamer or blocked altogether.
These more benign scenarios open the potential for renewed outperformance based on the long-term positives, including an aging global population and a growing middle class in emerging markets, all of whom will demand more extensive drug treatments and medical care over time. Balance sheets in the sector are solid, increasing the possibility of higher dividend payments, share-enhancing stock buybacks, and M&A.
The COVID-19 pandemic has been mixed for the sector. Some companies within the biotech and pharmaceutical industries stand to benefit if they produce tests and vaccines for the novel coronavirus, but at high cost and potential delays of other trials. Job losses and pandemic fears prompted many people to cancel elective procedures and delay routine care, leading to fewer diagnostic tests and drug prescriptions. It was a wash for many insurance companies, as lower insurance premium revenues were offset by lower claims. As economies reopen, we have seen much of this reverse, and indeed, the earnings outlook has improved.
There are still risks, however. Any legislation to control drug prices could weigh on pharmaceutical companies’ profits. Additionally, the Supreme Court is expected to rule on the constitutionality of the individual mandate provision of the ACA in 2021, and that could lead to the entire ACA being repealed. However, in the opening arguments heard on November 10, the majority of the justices indicated that a total repeal was unlikely, and there is little political appetite to allow chaos throughout the health-care system.

Positives for the sector:

• Strong balance sheets, with ample cash for dividends and M&A;
• Positive long-term demographics trends, including an aging global population and a growing middle class in emerging markets;
• Return in demand for elective procedures, drug sales, medical equipment and diagnostics;
• Valuations are attractive relative to the sector's historical average;
• Positive long-term price momentum.

Negatives for the sector:

• Hospitals have been squeezed by high COVID-19 preparation expense (although they received some stimulus relief);
• Higher unemployment reduces health care insurance enrollment;
• Extended-care facilities are likely to see higher costs related to virus mitigation requirements.

Risks for the sector:

• Supreme Court ruling on constitutionality of the Affordable Care Act (ACA);
• Bipartisan support for prescription drug price controls;
• Reversal of the 2017 corporate tax cut;
• Surge in COVID-19 could reduce demand for elective medical care;
• Unclear impact from any enhanced ACA legislation

Industrials: Marketperform

The Industrials sector includes aerospace and defense (e.g., airplanes, defense equipment) building products, electrical components and equipment, construction machinery, and services including transportation (e.g., airlines, railroads, trucking), construction, engineering and professional services.

The Industrials sector suffered significantly from the COVID-19-related global economic recession, with industrial output faltering as a manufacturing downturn broadened globally. This has prompted business leaders around the world to dramatically cut capital spending, stalling revenue growth for the sector. The Aerospace and Defense industry continues to face significant headwinds amid expected low airliner demand and uncertainty surround the political appetite for defense spending

With the economic recovery, however, the markets have begun to trade as would be typically seen in an early stage of the business cycle—which can be positive for this historically pro-cyclical sector. Additionally, prospects for an increase in infrastructure and clean energy investment has supported the machinery and building materials industries. Transportation and Air Freight have benefited from a return in demand as economies reopen, in addition to low fuel prices and interest rates. While the path of the economy remains highly uncertain, the recovery provides a nice macroeconomic tailwind for the sector. And despite ongoing woes in the airline industry—which has been decimated this year—the sector has sharply recovered since the market lows.

Positives for the sector:

• Capital expenditures are likely to increase if global growth continues to improve;
• The sector tends to outperform early in the business cycle;
• Many companies in the sector have cash-heavy balance sheets—although average fundamentals relative to other sectors.

Negatives for the sector:

• Capital expenditures have been tepid;
• Increased COVID-19 case count is a headwind for airlines;
• Aircraft demand is likely to be tepid;
• Poor relative valuations.

Risks for the sector:

• Upside risk if there is a stronger-than-expected surge in global growth or massive infrastructure stimulus.

Information Technology: Marketperform

The Information Technology sector includes software and services, technology hardware and equipment (e.g., mobile phones, personal computers), semiconductors and semiconductor equipment.

Information technology is a highly concentrated sector, with just a handful of companies representing more than 50% of the sector’s weight—including the two behemoths Apple and Microsoft. While those are typically the primary driver of sector performance, impacts related to COVID-19 have been broad-based and positive for much of the sector—increasing consumer demand for PCs, gaming hardware, software, personal devices and online payment services (at the expense of traditional credit card services by Visa and MasterCard).

Despite a surge in spending to accommodate remote working, weak capital expenditures—as well as trade tension and COVID-19-related supply chain issues—has been a concern. However, there are signs that investment in cloud and networking equipment is picking up, which could persist if the economic recovery continues. And the ongoing rollout of 5G wireless infrastructure is likely to accelerate—increasing demand for telecommunication components and semiconductors.

Long-term, a trend away from globalization and pent-up demand for productivity-enhancing technologies are likely to improve the already solid financial position for much of the sector. Counterbalancing the strong fundamentals and price momentum, investor optimism about future growth potential has pushed valuations to well above the historical average, and there are rising legislative and antitrust risks for some of the largest companies in the sector.

Positives for the sector:

• Generally strong balance sheets and earnings growth potential with low funding costs;
• Home office, financial services technology, and surging online retail are supporting cloud computing infrastructure and software;
• Long-term growth tailwinds, as businesses enhance productivity with tech investment.

Negatives for the sector:

• Valuations are stretched relative to the historical average;
• Capital expenditures are weak—albeit improving;
• The sector is highly concentrated in a few stocks.

Risks for the sector:

• Continued high unemployment could weigh on consumer technology revenues;
• Potential antitrust suits in the U.S. and Europe;
• Reversal of the 2017 corporate tax cuts that had greatly benefited the sector.

Materials: Marketperform

The Materials sector includes companies that make or process chemicals, construction materials (e.g., bricks, cement), containers and packaging (e.g., metal, glass, plastic, cardboard), forest products (e.g., lumber, paper), and metals and mining (e.g., aluminum, steel, copper, gold, silver).

The Materials sector is sensitive to fluctuations in the global economy and the U.S. dollar, concerns about the U.S.-China trading relationship, and the COVID-19 pandemic. Accommodative monetary and fiscal policies have begun to improve the prospects for global economic growth. This has allowed the U.S. dollar to trend lower, which historically provides a strong tailwind for the sector.

The sector still faces challenges, however. Global growth is not necessarily expected to provide an enduring tailwind to industrial metals or demand for chemicals (the largest industry in the sector). Although gas prices have rebounded off lows recently along with the price of crude oil, still-weak demand for gasoline continues to weigh on ethanol demand, although higher corn prices due to strong purchasing by China could increase demand for agriculture chemicals.

Positives for the sector:

• Optimism for an improving economy and weakening trend in the U.S. dollar;
• Reopening of the global economy has the potential to support chemical demand;
• Strong gold demand is supporting precious metals mining;
• Improving relative strength.

Negatives for the sector:

• Longer-term global growth is expected to be tepid, proving only modest growth in demand;
• Low energy prices and a decline in demand for ethanol is a headwind for oil fracking chemicals.

Risks for the sector:

• Lack of further stimulus amid a pickup in global COVID-19 cases;
• Potential stringent environmental regulations and reversal of the 2017 corporate tax cuts

Real Estate: Marketperform

The Real Estate sector includes equity real estate investment trusts (REITs) that invest primarily in commercial properties (e.g., office buildings, retail centers, apartment buildings), and companies engaged in real estate development and operation, such as real estate agents, brokers and appraisers.

The Real Estate sector’s domestic orientation and relatively high payout yields historically have made it attractive to investors, particularly in an environment of low and falling interest rates. Low interest rates also enable real estate investors to leverage property with relatively “cheap” money.

However, during periods of financial stress, as we’ve experienced with the COVID-19 pandemic, REITs tend to struggle. Commercial property demand has fallen, as much of the economy has yet to fully recover—which increases the risk of lease defaults, particularly for Retail and Hotel REITs. While net debt for the sector is low by historic standards, the risk to cash flow puts many REITs in a difficult position.

The outlook for the sector will be highly dependent on the speed at which the economy recovers and consumers’ attitude towards social distancing. While government support payments to businesses and newly unemployed workers will help, a slow, drawn-out recovery would become a longer-term headwind for the sector. However, if the economy recovers more quickly, people get back to work and interest rates stay low as the Federal Reserve maintains accommodative monetary policy, the Real Estate sector stands to benefit. In a low-interest-rate environment combined with renewed economic growth, investors’ search for yield could be a strong tailwind for the sector.

Positives for the sector:

• Optimism for improving economic growth;
• Low interest rates are positive for funding;
• Investors often turn to REITs for dividend income when prevailing interest rates are low.

Negatives for the sector:

• High unemployment can lead to multi-family lease defaults;
• A sharp turn higher in home-ownership rates is a negative for multi-family housing;
• An accelerated shift to internet from brick-and-mortar stores puts retail REIT revenues at risk;
• Behavioral shift away from long-term care and shared office space.

Risks for the sector:

• A quicker-than-expected rise in interest rates.

Utilities: Underperform

The Utilities sector includes electric, gas and water utilities; independent power producers and energy traders; and companies that produce electricity using renewable sources (e.g., solar, wind, hydropower).

The Utilities sector has tended to perform relatively better when concerns about slowing economic growth resurface, and to underperform when those worries fade. That’s partly because of the sector’s traditional defensive nature and steady revenues—people need water, gas and electric services during all phases of the business cycle. And low interest rates that typically come with a weak economy provide cheap funding for the large capital expeditions required in this industry.

However, valuations have been driven up in recent years as investors have reached for yield in this new era of low interest rates; this may decrease the sector’s traditional defensive characteristics. And while interest rates are expected to remain generally low, they could edge higher as the economy continues to expand. On the flip side, there is the potential for a renewed decline in the economy to push rates even lower, or there could be significant government funding to Utilities as part of clean-energy initiatives that would benefit the sector’s profit outlook.

Positives for the sector:

• Generally stable revenues;
• Investors often turn to utilities for dividend income when prevailing interest rates are low;
• Low yields provide low funding costs for this capital-intensive sector.

Negatives for the sector:

• The sector has not acted as defensively during recent periods of market weakness as in the past;
• Valuations are high relative to the sector’s historical average;
• Economic recovery makes the sector less attractive relative to other sectors.

Risks for the sector:

• Uncertainty regarding potential clean-energy legislative funding;
• Higher interest rates due to unexpected rise in inflation.

What do the ratings mean?

The sectors we analyze are from the widely recognized Global Industry Classification Standard (GICS^®) groupings. After a review of risks and opportunities, we give each stock sector one of the following ratings:

• Outperform: likely to perform better than the S&P 500 index
• Underperform: likely to perform worse than the S&P 500 index
• Marketperform: likely to track the S&P 500 index

Our view on individual sectors

Schwab Sector Views can be useful in identifying stocks by sector for potential purchase or sale. Schwab clients can use the Portfolio Checkup tool to help ascertain and manage sector allocations. When it's time to make adjustments, clients can use the Stock Screener or Mutual Fund Screener to help identify buy or sell candidates in particular sectors. Schwab Equity Ratings also can provide an objective and powerful approach for helping you select and monitor stocks in each sector.