You don’t have to own bank stocks to make money when rates are rising. While financials derive the biggest benefit, other sectors such as equipment makers, material manufacturers and energy producers also do well in a rising-rate environment. Steelmaker Nucor (ticker: NUE), metals miner Freeport-McMoRan (FCX), capital goods manufacturer Emerson Electric Company (EMR), truck maker Paccar (PCAR) and oil producer ConocoPhillips (COP) are all interesting plays right now. More on our picks later.
Of course, if interest rates rise and then collapse again as they did from March 2021 to August 2021, the party will be over before it really heats up. But there is reason to think rates may stay up for a while this time. Inflation is spiking, and the Federal Reserve suggested it will soon reduce its bond buying. Less money moving into bonds drags their prices lower, lifting their yields.
Recently, the yield curve — the difference between long-dated bond yields and short-term rates — has expanded as the 10 Treasury year yield has popped. This means markets see higher long-term inflation, which is often driven by strong economic demand. Demand for manufactured goods and oil usually rises.
But the yield curve expansion likely isn’t over. Within the next several quarters, the spread between the 10-year and 2-year yields, currently 1.18 percentage points, can hit 1.7 percentage points, says Dennis DeBusschere, president of 22 Research.
Financial stocks are the biggest winners, and it’s already being reflected in their share prices. Not only do banks lend more when the economy is expanding, but each loan is more profitable because banks can borrow at low short-term rates in order to lend at higher long-term rates. Financial stocks on the S&P 500 are the most correlated to changes in the yield curve out of any sector in the last 10 years, according to Jefferies.
But there are other sectors that can see big stock gains. Since 2010, S&P 500 materials, industrials and energy stocks have had the second, third and fourth highest correlation, respectively, to the yield curve, according to Jefferies. Those sectors should see anywhere from 13% to 15% annualized gains if the yield curve expands, DeBusschere says.
A steepening yield curve indicates investors are pricing in a higher likelihood of improving economic growth and faster earnings growth for economically-sensitive companies. They’ll often pay a higher price for those “cyclical” stocks.Already, these stocks have rallied. The Materials Select Sector SPDR Fund (XLB), Industrial Select Sector SPDR Fund (XLI) and Energy Select Sector SPDR Fund (XLE) are up 5.1%, 4.7% and 22%, respectively, since the close on Sept. 21 before the Fed spoke. Still, “I think industrial cyclicals and materials will do pretty well over the next 6 months,” says Doug Ramsey, chief investment officer of The Leuthold Group. “I do think the curve is going to steepen further.”
Back to our five stocks. All place in the top 40 stocks most correlated to the yield curve out of all S&P 500 names. Nucor trades cheaply and may not reflect its profits potential. It trades at 6 times projected earnings per share for the next 12 months, lower than its 5-year average of 12 times, according to FactSet. The price of hot rolled coil is currently a lofty $1,800 per unit because of supply shortages, but everybody thinks it will fall sharply. Nucor’s current valuation indicates a future steel price of $750, but Curt Woodworth, a Credit Suisse analyst, thinks it will remain above $1,000. That makes Nucor a good buy, he says.
He sees 2022 EPS coming in 67% higher than current estimates. “It’s kind of an easy thing to do to say everything [earnings] mean reverts,” Woodworth says. “Normalized earnings power is significantly higher than people realize.”
ConocoPhillips is similar. Analysts will likely revise EPS estimates higher soon, says John Freeman, Raymond Jaymes analyst. Analysts are looking for 2022 EPS of $6.39, but they haven’t yet accounted for a recent surge in oil prices. “Estimates are going to be getting revised up,” Freeman says. “Commodity prices have gone up so much in the past six to eight weeks.”
Meanwhile, the stock may not reflect much of that earnings stream. The company’s enterprise value is just under 5 times expected 2022 earnings before interest, tax and noncash expenses. Historically, it often trades at a roughly 7 times multiple, Freeman says.
The other three stocks also show strong vital signs for more stock gains. Emerson Electric has risen 2.5% since Sept. 21. It trades at about 20 times earnings, in line with its 5-year average, so it may have room to run on solid earnings reports, even if analysts don’t up their forecasts. Analysts polled by FactSet expect EPS to grow in 2022 and then to rise 9% in 2023, which the stock will be pricing in by the end of next year. The company reports earnings Nov 3.Freeport McMoRan has risen 28% since Sept. 21. It trades at 11 times earnings, cheap compared with its 5-year average of 15 times, while EPS is expected to grow 19% in 2022. Earnings are out Oct. 21.
Paccar stock has gained 10.4% since Sept. 21, trades at 13 times earnings, cheaper than its 5-year average of 14 times and is expected to see EPS grow 27% next year and 9% in 2023. Earnings are on Oct. 26. Get ready for the second act of the cyclical stocks.
Write to Jacob Sonenshine at jacob.sonenshine@barrons.com
Source: finance.yahoo.com