Sector Opportunities for Q3 2024

Utilities: Attractive valuations, peaking interest rates, and secular increases in power consumption make the sector a promising underdog.

Aerospace and Defense: Higher defense spending in the face of global conflicts points to great growth potential for the industry.

Oil & Gas Exploration and Production: Constructive supply-demand balance supports the industry fundamentals, while its high sensitivity to inflation and oil prices provide investors a powerful portfolio diversification tool.

The S&P 500 Index gained for the third consecutive quarter in Q2, extending its year-to-date rally to 15.3%,¹ despite a delayed first rate cut by the Federal Reserve (Fed) and heightened political and geopolitical uncertainties in Europe and the Middle East. Nevertheless, the market breadth has narrowed, with the Tech sector contributing nearly 100% of the index’s Q2 return and Communication Services being the only other outperforming sector. Meanwhile, the 21x next-12-month earnings multiple, which is close to the level last seen in December 2021, appears stretched given elevated interest rates and slower growth outlook.²

For sector positioning in the second half of this year, we identified three underdogs with positive or better-than-consensus earnings growth prospects — Utilities, Aerospace & Defense, and Oil & Gas Exploration and Production.

Utilities: The Secular Increase in Power Consumption

Utilities has lagged the broad market by 45% on a cumulative basis since the market bottom in September 2022. Elevated bond yields have increased the sector financing costs due to its capital-intensive business, while increasing soft-landing prospects mean the sector’s defensive trait is out of favor. As a result, Utilities’ next-12-month P/E is trading at a 21% discount to the broad market — close to its 15-year low.³

But Utilities earnings growth has shown great resilience in the current high interest rate environment thanks to cost control measurements and expanded rate bases (Figure 1). The S&P 500 Utilities sector posted EPS growth of 6.5% in 2023,on par with the Tech sector and outpacing 1% growth rate for the broad market.⁴ Its EPS growth is expected to accelerate to 9.3% in 2024 and maintain at 9% in 2025, well above its 10-year growth average of 4.5%.

While higher interest rates have burdened the sector with high financing costs, the decline in non-fuel operating and maintenance expenses helped mitigate the impact of higher financing costs on the bottom line. Record increases in capital spending after the pandemic has increased the Utilities’ rate base.⁵

Together with a higher interest rate environment, utility companies can make a strong case in front of utility regulators for increasing allowed return on equity in their upcoming rate cases, boosting their profitability.

Over the longer term, booming data center power consumption, electrification of the transportation sector, and manufacturing reshoring provide secular tailwinds for demand growth in electric utilities. Electricity consumption from data centers could more than double by 2026, assuming no significant improvement on technological efficiency.⁶ With increasing adoption of electric vehicles, electricity demand from the transportation sector is projected to increase more than eight times by 2050.⁷

Last but not least, electricity demand from the industrial sector may get a boost from manufacturing onshoring. Based on the analysis of onshoring US manufacturing facilities that has been announced or begun construction between 2021 and 2023, they may increase annual industrial electricity consumption by around 0.65% relative to the 2022 level.⁸ As the pace of reshoring accelerates, US industrial electricity demand may see the first sustained increase since 2000.⁹

While Utilities still faces near-term headwinds from elevated interest rates, long-term Treasury yields have shown signs of peaking, as so far the Treasury yield has peaked below last year’s highs. This may indicate that the worst rate pains may be behind the sector. Current valuation levels offer attractive entry points for investors.

To add defensive positions in a slower growth environment while capturing the brighter growth prospect in the Utilities sector, consider the Utilities Select Sector SPDR Fund (XLU).

Aerospace & Defense: Higher Defense Spending and Potential Tailwinds After the US Election

The Aerospace & Defense industry has underperformed broad US equities and its European peers by more than 10% year to date¹⁰ due to US defense budget and supply chain constraints. But looking beyond the near-term headwinds, we remain positive on the multi-year cycle of higher defense spending amid intensifying competition between powerful nations and increasing geopolitical fragmentation.

While the US defense budget for FY 2024 and 2025 was constrained by last year’s debt ceiling deal limiting the defense budget increase to 1% from the previous year, global military expenditures continue to show strong momentum led by increases in Europe and the Middle East. As European countries’ threat perceptions were dramatically shifted by the Russia-Ukraine war, we saw the highest number of NATO members meeting or surpassing the 2% of GDP on defense spending target last year, lifting the region’s defense spending by 16%.¹¹

Military expenditures in the Middle East registered the highest annual growth since 2014, driven by large increases in Saudi Arabia and Israel¹² as diplomatic relations between Israel and Arab countries deteriorated amid the war in Gaza. Iran’s retaliatory attacks on Israel and Israel’s military response in April heightened the risk of wider regional conflicts, potentially boosting Arab countries’ military spending in the coming year.

Additionally, the intensifying rivalry between the US and China around the Taiwan Strait demands higher spending on US defense modernization in the Indo-Pacific region to deter military threats. Notwithstanding debate on whether China’s official defense budget captures most of its actual defense spending, the US share of global military spending has declined over the past decade, while China’s share of global spending has increased (Figure 2).

Although the FY 2024 US defense budget is more than triple China’s in absolute terms, US defense spending has a global footprint, compared to China’s Indo-Pacific focus. Moreover, the same dollar amount allows China to go further in military buildup and modernization given its lower domestic labor and material costs.

With established higher global defense spending trends and bipartisan agreement on strengthening military competitiveness to maintain US global dominance, the recent stall in defense budget growth may be revisited after the US presidential election, regardless of the party that controls the White House and Congress.

Defense stocks have historically outperformed the S&P 500 in eight of 10 election years by an average of 9% since 1984 (excluding the more than 30% outperformance in 2000). Given defense’s year-to-date underperformance and potential political tailwinds following the election, the industry may play catch up in the second half of this year. Meanwhile, the 33% gap between the defense modernization budget and actual cash outlays over the past 12 months may sustain defense contractors’ revenue growth of 10% in the next two years given their historical high correlation,¹³ supporting the industry’s growth outlook.

To capture the secular increase in defense spending and potential political tailwinds following the election, consider the SPDR® S&P® Aerospace & Defense ETF (XAR).

Oil & Gas Exploration and Production: A Catch-up Play with Oil Prices While Hedging Inflation and Geopolitical Risks

While crude oil prices have rebounded from below $75 per barrel in June, stocks of oil & gas explorers and producers continued the downward trend, lagging the performance of crude oil prices and broad equities by 15.2% and 6.6%, respectively, over the past year¹⁴ (Figure 3). On the other hand, the industry has shown positive earnings sentiment in Q2, with 2024 and 2025 earnings growth estimates revised higher and the number of upgrades exceeding downgrades by large margins. Lower stock prices and stronger earnings have kept the industry forward P/E valuations at the bottom quartile of the past 10 years and around 50% discount to the broad market.¹⁵

Soft demand, inventory buildup, and growth in US shale production have been the major concerns in the oil market, even though in its June meeting OPEC+ extended the voluntary production cuts to September and the broader output cuts a year beyond their scheduled timeline.

While the increase in US crude oil inventory appears alarming, the current inventory level is merely on par with last year’s level. The upcoming seasonal higher demand and the OPEC’s voluntary production cuts throughout the summer increase the odds of crude oil inventory decline in Q3, supporting oil prices. Considering the crude oil refinery forecast runs in the following month, days of crude oil supply excluding Strategic Petroleum Reserve are actually shorter than last year.¹⁶

The surprisingly strong growth in US shale production in the second half of last year caught energy investors off guard, with WTI crude oil prices closing the year around $70. The steeper-than-normal drawdown of the drilled but uncompleted wells inventory was likely behind the jump in production.¹⁷ The risk of repeating a positive supply surprise is limited given the low inventory of drilled but uncompleted wells and last year’s 30% decline in US horizontal rig counts, a leading indicator of shale oil production trends. Indeed, the three-month moving average of US oil production registered its fourth straight month of negative three-month growth in April.¹⁸

Potential softer demand amid a sharper global economic slowdown later this year poses a key downside risk to energy related exposures. However, the near-term supply and demand balance is constructive given continued OPEC output cuts, the resilient US economy, and global manufacturing recovery. The OPEC+’s recent track record of constraining supply to support oil prices may also help limit downside risk. And the potential negative supply shock driven by a wider regional conflict in the Middle East may create a deficit in the oil market, bolstering energy stocks’ outperformance over the broad market.

The SPDR® S&P® Oil & Gas Exploration & Production ETF (XOP), which has exhibited higher beta to oil prices and inflation expectations than the broader energy sector,¹⁹ may help investors capture the upside potential of oil prices while mitigating the negative impact of upside inflation surprises and broadening Middle East conflicts at attractive valuations.

To learn more about emerging sector investment opportunities, visit our sectors webpage.