Question #2 for 2018: Which Sectors Are Best?
We are running a special 3-part series this week on investment themes for 2018, so we’ve asked each of our analysts to respond to the following question:
“Which sectors/geographies do you believe will perform the best in 2018?”
I believe companies that produce hard assets and basic material will be the big winners in 2018 as the Fed raises interest rates to combat inflation. The U.S. economy appears to be fully recovered from the Great Recession, with a tight job market spurring wage growth.
That will drive up commodity prices, creating bigger profit margins for the companies that source them. That will benefit energy, mining and agricultural companies all over the world. The losers will be manufacturers that purchase hard assets and basic materials, since their profit margins will decrease at the same time.
In terms of geographies, developing markets that produce natural resources should perform particularly well, while those that rely primarily on tourism could be hurt by the double whammy of higher travel costs and reduced purchasing power caused by rising inflation.
I addition to aerospace/defense, banking and health services are positioned to outperform in 2018.Financial stocks have racked up huge gains since Trump’s election, a rally driven by robust economic data and the expectation that the administration will deregulate Wall Street. This momentum should continue.
GOP-led efforts to cut the corporate tax rate constitute a windfall for banks, because they tend to take fewer deductions. Banks also are happy about the prospect of a laissez-faire businessman in the White House who’s intent on deregulating financial services.
High on the list: eliminating the Dodd–Frank act. Advocates of Dodd-Frank say it will prevent another 2008 crash. Banks say it ties their hands. The Federal Reserve is tightening the monetary spigot, with three more rate hikes planned for 2018. The widening rate spread makes it easier for banks to make money on loans.
Health care will continue to benefit from unstoppable trends that are resilient to economic and financial cycles. People need medical care, especially as they get older and sicker, whether the economy is growing or not. Around the world, populations are aging and middle classes are rising. That spells long-term demand for doctors, hospitals and drugs.
Given the geopolitical risks in the oil-producing Middle East and Venezuela outlined above, energy is the best industrial sector to own during 2018. Oil inflation could cause all commodity prices to soar, which will benefit small, commodity-focused emerging markets the most. I would avoid the obvious but troubled beneficiaries in the war-torn Middle East and focus on five oil-producing countries elsewhere: Colombia, Indonesia, Malaysia, Nigeria, and Russia.
Because economic momentum is building throughout the world and global inflation will pick up 2018, commodities other than oil will also do well. First on my list is copper, known as the commodity with a Ph.D. in economics because its price is highly correlated with economic growth. In 2017, the orange metal experienced its best price performance since 2009, but this positive price action signals a technical breakout that promises to keep going.
The supply situation for copper is stable, so price rises caused by increasing demand will not be quickly thwarted by the entrance of new producers. Two of the world’s largest copper producers are Chile and Peru.
Europe will continue to do well albeit at a slower pace than 2016. The logistical implications of executing Brexit will dampen some of the robust demand many domestic companies have enjoyed from their European customers.
Retail and drug sectors will do well. Both are oversold and have suffered negative operating environments this year. A plethora of retail brick-and-mortar bankruptcies should concentrate demand to those left standing.
Trades within the drug sector need to be focused on those companies boosting revenue via prescription volume growth. Despite what may be a dulled focus on drug price inflation, companies that have relied on double-digit price increases will suffer. Those with new innovative drug introductions will do well.
MLPs have been unfairly punished this year, even as energy prices have generally climbed higher.
The benchmark Alerian MLP Index is down about 14% year to date, compared to a gain of about 20% gain for the broad market. There’s no one obvious factor behind the MLP market’s sour sentiment, especially over the past few months.
Regardless of the reason for the decline, it’s prompted the MLP space to get more financially conservative. Some big players are retaining more cash flow to shore up balance sheets and invest in future growth. Others are simplifying their ownership structure to free up cash flows.
With the supply-demand balance tightening after years of working off the boom-time glut, oil prices should continue to head higher.
Oil producers and oilfield services providers with major operations in the Permian Basin should fare well in 2018. This region is home to significant oil production at the lowest breakeven prices in the U.S. The midstream sector — particularly the long-suffering master limited partnerships (MLPs) — has diverged from oil prices in recent months.
That divergence can’t continue, because it has created a significant disconnect between the valuation of the midstream sector and the likely financial performance of the sector as oil prices continue to recover. Look for the undervalued midstream sector to bounce back in 2018
Commodities will be strong in 2018, reflecting China’s continued growth along with growth throughout the East and to some extent in the West as well. Gold prices will rise both because of its expected role as a currency in Eastern oil trading and because gold always does well when commodities are strong.
Other companies that I think will be market standouts are technology manufacturers; in particular, semiconductor companies. China, again, is part of the reason. The megacities China is creating, encompassing huge numbers of people and businesses over large geographic areas, will create a need for interconnectedness on a scale never before imagined. They will be prime movers of the Internet of Things (IOT).
Slower sales growth of some major drugs and pricing concerns have dulled investor enthusiasm for the biotech sector. The “Big Pharma” players are generally trading at forward price-to-earnings ratios (P/Es) below that of the S&P 500. Yet fundamentally the sector looks strong. Innovation continues. The FDA has approved 42 novel drugs and biologic products in 2017, up from just 22 in 2016.
Biopharmaceutical companies are still successfully developing and bringing new products to the market even as investor attention has turned elsewhere. Looking toward 2018, Big Pharma will have key clinical data readouts, potential new FDA approvals and product launches as potential catalysts. Dozens of others in the biotech space, big and small, also have key data readouts to come in 2018. Given currently low expectations, a breakthrough or two should reawaken investor interest in the sector.
I also expect 2018 to be a year of consolidation in the drug sector as the cash-rich heavyweights seek to boost growth by taking over the smaller fishes. This should likewise help to boost investor sentiment.