Sector Outlook: Seasonal Factors, Monetary Policy, Interest Rates

The sector outlook for the weeks ahead could hinge in part on Fed rate policy and chances for a tax cut.

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This month's Fed rate hike, traditional late-year trading tendencies, and the potential passage of U.S. tax reform could help determine stock sector performance in the days and weeks ahead.

These events—along with the fact that tech easily leads all sectors in 2017 performance—conceivably could usher in a scenario where financial stocks and other so-called “cyclicals” like industrials and materials build on recent gains while technology stocks continue to run in place or retreat slightly, some market professionals said.

“I’d expect pressure on tech, as you tend to see pressure on sectors at the end of the year that have significantly outperformed the market,” said JJ Kinahan, chief market strategist, TD Ameritrade. “Some people want to book profits for the year, and it can be hard for a sector to continually out-perform the market.”

Kinahan added that financials “could be interesting to follow” because theoretically both a tax cut and rising interest rates might benefit the sector.

However, the lead-up to new year might be harder to forecast than usual because it’s still unclear what the final tax reform package might look like, or even if it will pass, Kinahan noted. Congress has given itself a Christmas deadline, and questions remain to be ironed out.

“Sector rotation is normally very active at this time of year,” Kinahan said. “With the looming tax proposal on the horizon, one of the things delaying or making sector rotation more difficult is when to realize your capital gains. Stock indices are up significantly and people are deciding whether to realize capital gains in 2017 or 2018. As we get more clarity on taxes, we could see a really busy last week of the year.”

Tech Momentum Among the Question Marks as 2018 Nears

Patrick O’Hare, chief market analyst at Briefing.com, agrees that other sectors might have a bit of a leg up on info tech. Although from a historic basis nearly every sector is arguably rather richly valued, tech is on the high end of the scale, which could make other sectors seem more appealing to some investors.

“Because tech has been such a huge out-performer, people have been moving into stocks seen as more fairly valued and with stronger potential for upside earnings surprises,” O’Hare said. “So a lot of under-performers like financials, transports, industrials, and retail stocks have all benefitted.

“It’s a relative trade,” O’Hare added. “Because the tech sector has done so well, there are some concerns building up about a crowded trade and an over-owned sector, so there’s a reallocation into areas that seem less crowded.”

Getting “Cyclical” in the New Year

Looking into 2018, Sam Stovall of research firm CFRA believes “cyclical” sectors might be among the strongest performers. The firm sees financials benefiting from “improved loan growth, a steady pace of interest rate increases, a steepening of the yield curve, and deregulation.” The industrial and material sectors might benefit from tax cuts, improved economic growth, and potential infrastructure spending, Stovall added, and he’s “overweight” on those as well.

Info tech doesn’t get as big an endorsement from Stovall, who rates the sector “market-weight” due in part to what he says is “wavering price momentum and below-market 2018 EPS growth estimates.”

Stovall is also overweight on health care; market-weight on consumer discretionary, energy, real estate, and utilities; and underweight on consumer staples and telecom as the market enters the new year.

Interest Rate Hike Seen Helping Certain Sectors, Hurting Others

Turning back to interest rates, the Fed’s third hike of the year — which took place Dec. 13 — might help some sectors more than others, if past precedent holds.

“A rise in interest rates by the Fed is viewed as a sign of confidence in the economic outlook, and that should ultimately play into the strength of cyclical sectors which should be benefiting from better economic activity, including consumer discretionary, industrials, and financials,” O’Hare said.

However, rising interest rates could hurt other sectors. “If you see higher interest rates, there might be less interest in seeking yield in utilities and telecom, which could be a headwind for those sectors,” O’Hare said.

One sub-sector that could be caught between a booming economy and rising rates is housing.

“If you’re a believer in growth, you may believe the housing market is going to continue to be strong,” Kinahan said. “But rising interest rates might work against it long-term, and some tax proposals could affect housing, including changes to mortgage deductions and local and state tax deductions. It’s a big question mark.”

With that in mind, investors might want to keep an eye on some of the home construction and homebuilder supply stocks for any reaction to the ultimate tax bill.

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