Energy, financials, real estate sectors riding inflation wave

At the midway point of 2021, the financial markets are signaling a focus on inflation. Through June, three of the sectors that fared the worst in 2020 are this year's top performers.

The energy sector, which fell by 37.2% last year, is up 42.4% through June this year. The financial sector, which declined by 4.1% last year, is up 24.5%, and real estate, which lost 5.2% last year, is up 21.7%.

“Investors are still focused with an eye toward inflation,” Sam Stovall, chief investment strategist at CFRA, said of the sectors' showings.

Of the 11 sectors making up the S&P 500 index, four were negative last year when the S&P gained 16.3%.

So far this year, the utilities sector was the worst performer, with a gain of 0.8% following a 2.8% decline last year. Through June, the S&P was up 14.4%.

Energy's strength this year is driven by both the reopening of economies and the threat of inflation, Stovall said

“Since 1970, if you look at months with steepening yield curves, or higher year-over-year [inflation] the best sector was energy,” he said. “There was too much supply last year and not enough demand because of the Covid shutdowns, and energy had been out of favor for so long, so investors didn’t want to make any big bets on energy until they started to see some turnaround data.”

Financials are also benefiting from the steepening of the yield curve, which results from a widening of the gap between yields on shorter-term and longer-term bonds.

“History says financials tend to do well in steepening yield curve environments,” Stovall said. “Since the Fed is digging in its heels regarding short-term rates, and longer-term rates are creeping higher, that’s where the banks are making their money.”

As a part of the financial sector, banks are also benefitting from June’s positive stress test results, which are expected to drive increased dividends.

Energy, financials, and real estate are also part of the value investing trend that started to take off at the end of last year.

Real estate, which traditionally does well in inflationary environments, is benefitting from yields on real estate investment trusts that are double that of the 10-year Treasury.

“That is a tempting meal for income-starved investors,” Stovall said.

Real estate performance this year is another example of the stark contrast resulting from concerns over commercial and residential real estate as the pandemic gained traction and threatened income streams.

Paul Schatz, president of Heritage Capital, has subscribed to a general theme of small-cap over large-cap stocks and value over growth, but said there have been a few “pivot points.”

“I was very positive on energy, financials, materials and industrials, and that pretty much was the case through May,” he said. “There was an odd pivot in the middle of May when we saw that super-hot inflation. And the markets actually went the other direction regarding future expectations for inflation.”

The wild card in the second half, Schatz said, will be inflation.

“The cyclical area peaked in May as well as value and small caps, versus everything else, and growth and large caps begin to outperform and that definitely surprised me,” he said. “The market is telling us growth in the economy and earnings should begin to decelerate. When you see bond yields peak on a very hot inflation number and growth and large caps begin to outperform at the same time as materials, industrials, financials and energy all peak, something is amiss for the hot inflation theme during the second half of this year.”