Analysts have looked to the energy sector to boost the market as the US economy continues to emerge from the current low interest rate environment.
“I’m actually very bullish on materials and even more bullish on energy going forward,” Aptus Capital Advisors portfolio manager David Wagner told Yahoo Finance Live. “So if we go back to later periods in the early 2000s and other periods where we actually saw rates go up, so Fed tightening, you always saw defensive outperformance.”
Energy Select Sector SPDR (XLE), an exchange-traded fund made up of companies that sell oil and natural gas or energy equipment and services, hit a 52-week high in yesterday’s rally before falling more than 2% on Thursday.
Markets plunged on Thursday, giving up gains made in a bullish trading session on Wednesday as investors anticipated the Federal Reserve’s first half-point rate hike in more than two decades. The S&P 500, Nasdaq and Dow Jones Industrial Average all fell on Thursday after the Fed announced it would begin trimming its balance sheet – which currently stands at $9 trillion – from June 1. The plan was mostly in line with Wall Street consensus estimates.
“Our quantitative macro models at the moment show that energy has actually, somewhat oddly, become a bit more of a defensive game,” Hugh Roberts, head of analytics at Quant Insight, told Yahoo Finance Live yesterday. “It’s actually one of the few sectors that’s comfortable with wider credit spreads.”
A credit spread is the difference between two fixed income securities. Generally speaking, wider spreads are associated with expectations of a stable economy, while narrower spreads are associated with fears of economic contractions, although this is not always the case.
“Credit spreads are really, in our modeling, at ground zero,” Roberts said. “If we see another episode of risk aversion that pushes high yield spreads, in particular, wider, then that’s really the catalyst that would be there.”
It remains to be seen whether or not this catalyst will occur, although the stock market has shown no difficulty in taking investors on unforeseen risks, especially in recent memory.
Energy companies may be particularly well positioned to benefit even if other companies suffer from monetary tightening, Roberts noted.
“We don’t worry that much about the Fed,” he said. “What concerns us are credit spreads. That’s really the connection between all of these pressure points right now… And oddly enough, it’s counter-intuitive, but the mathematical relationship right now shows that wider credit spreads actually benefit XLE.
The energy sector is currently underheld in the market, Wagner said.
“And what we’ve said about energy is that it’s maybe a bit overbought right now, but it’s entirely underheld,” he said. “If you look back over the last, say, 40 years, the average weight in the S&P 500 for the energy sector is closer to 11%.
The energy is currently only 3.7% of the S&P 500, as the information technology, health services, consumer discretionary and financials sectors account for well over 60% of the index’s weighting. This year, the energy sector has outperformed all sectors of the S&P 500 by far, as commodity prices have soared following Russia’s invasion of Ukraine.
Energy companies are also notable for engaging in capital discipline, a practice whereby a company foregoes large investments in capital expenditure and prioritizes returning cash to shareholders.
“Energy companies come out and say, hey, we’re not putting 125% of free cash flow into the ground,” Wagner said. “We’re actually going to pay out 75% or 50% of free cash flow from the previous quarter to investors through share buybacks, through dividends. So they’ve really changed their mentality saying, ‘Hey, that’s not growth at all costs, we’re going to be diligent from a capital allocation plan going forward.” So we like energy.
Ihsaan Fanusie is a writer at Yahoo Finance. Follow him on Twitter @IFanusie.