By Cyclical stocks have the potential to experience a boost as the rate of inflation continues to decline. These are companies that witness significant fluctuations in sales and profits in response to changes in the economy. Some examples include materials producers like steel makers and copper miners, as well as restaurants and consumer goods companies.
When the public has more money to spend, materials producers benefit from increased demand, while restaurants and consumer goods companies also enjoy a similar advantage. In addition, banks tend to lend more and complete more transactions when demand improves. Investment-management companies also experience gains when the market rises, as this increases the assets they oversee and subsequently boosts their fees. It’s worth noting that although industrials typically benefit as well, their potential for growth may be limited since they have already seen recent gains.
The impact of inflation on these companies can be seen in two ways. Initially, when prices begin to rise, it serves as a positive signal that demand is increasing. Higher prices can lead to increased revenue, assuming sales volume doesn’t decrease significantly.
However, the problem arises later in the economic cycle when inflation reaches a level that prompts the Federal Reserve to raise interest rates and curb demand for goods and services. The Federal Reserve began taking such actions in early 2022. At this point, investors hope for a decline in inflation so that rates can be reduced, encouraging consumption and enabling the economy to continue growing.
If the consumer price index (CPI) for February, set to be released next month, is lower than expected, it is expected that cyclical stocks will experience positive movement.
While certain economists have yet to release forecasts for February’s CPI gain, there is enough evidence pointing towards a continued moderation of inflation. In January, the CPI rose by 3.1%, down from its peak of just over 9% in 2022. The Federal Reserve aims to bring it down to its target of 2%.
According to Dennis DeBusschere of 22V Research, the cost of services, which was a significant contributor to January’s unexpectedly high CPI result, often moderates after the first month of the year. This trend was observed in 2023. As the CPI moves closer to 2%, there is an increased likelihood that the Federal Reserve will reduce rates in order to support economic growth.
The Link Between Inflation and Cyclical Stocks
The recent hotter-than-expected CPI data has had a negative impact on cyclical stocks. On the day of the report, the Materials Select Sector SPDR Fund dropped 1.4%, while the SPDR S&P Metals & Mining exchange-traded fund declined 3.9%. The Financial Select Sector SPDR Fund fell 1.3% and the Consumer Discretionary Select Sector SPDR Fund dipped 2%.
However, if inflation were to come in lower than expected, it could have the opposite effect. According to DeBusschere, lower inflation could support the case for cyclical stocks and risk-on factors through 2024.
Another factor that makes these stocks appealing is their reasonable valuations. The materials ETF currently trades at just over 19 times the aggregate per-share earnings analysts are predicting for the coming year. This is below the S&P 500, which trades at just over 20 times earnings. When the demand outlook for steel and other materials improves, the materials ETF often trades in line with the index.
Similarly, the metals and mining ETF is trading at just under 15 times earnings, well below the S&P 500. Although the discount has been wider in the past decade, there is still room for the shares to rise, especially considering that copper prices remain below their previous highs.
The financials ETF is also trading at 15 times earnings, offering a 25% discount compared to the S&P 500. In the past decade, it has intermittently traded in line with the market for extended periods.
On an equal-weighted basis (excluding Tesla and Amazon.com), the consumer ETF trades at just over 15 times earnings. It has also traded in line with the market in recent years, with the lowest figure being slightly below 13 times.
Taking all these factors into account, there is potential for a favorable trade in the near term.
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