Despite a Leadership Shift in Stocks, Bofa is Bullish on the S&P 500 Materials Sector

Bank of America (BofA) strategists have expressed a positive outlook on the U.S. stock market’s materials sector, citing an expected rebound in earnings after the Federal Reserve began cutting interest rates in September. This optimism stems from a combination of factors, including the impact of interest rate cuts and global economic trends that could benefit the sector.

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In a recent note released on Tuesday, BofA Global Research equity and quantitative strategists announced their decision to upgrade the materials sector to "overweight" from "marketweight." They based this shift on the belief that the Federal Reserve is cutting rates as the U.S. economy moves into an "accelerating profits cycle." The strategists pointed to a correlation between the materials sector and broader economic factors, particularly in relation to China, whose government recently unveiled a stimulus program aimed at boosting its economy. They noted that among the 11 sectors in the S&P 500, the materials sector has the strongest connection to the MSCI China Index.

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The Fed’s decision to start cutting its benchmark interest rate last month followed a period of aggressive rate hikes designed to combat high inflation. Inflation, which reached significant highs in 2022, has now decreased substantially. This shift in monetary policy is seen as a potential boon for earnings in the materials sector, which experienced one of the sharpest downturns during the period of rate hikes.

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"Materials saw the biggest earnings swoon of all sectors since hiking began," the BofA strategists explained. However, they believe that this presents a substantial opportunity for recovery. As the Federal Reserve continues to reduce interest rates, the materials sector is positioned to benefit from an "accelerating profits cycle," which could drive a significant rebound in earnings. To support their analysis, the strategists included data tracking the earnings of the S&P 500 and its 11 sectors through the second quarter of 2024 compared to 2021.

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In addition to the favorable interest rate environment, BofA’s strategists highlighted the effects of "a decade of underinvestment in manufacturing," particularly in areas such as mining and equipment replacement. This underinvestment, they argue, creates the potential for higher returns as companies ramp up capital expenditures in these areas. The strategists emphasized that this "old school" cycle of capital spending, combined with ambitious decarbonization goals, should support demand for metals, mining, and other commodities—key drivers of the materials sector’s growth.

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The materials sector of the S&P 500 has already outperformed the broader market. In the third quarter of 2024, the sector posted a gain of 9.2%, outpacing the S&P 500’s overall rise of 5.5% during the same period, according to data from FactSet. By the end of September, the materials sector had posted a 12.6% gain for the year, reflecting its strong performance relative to other areas of the market.

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As of late September, the materials sector was one of several cyclical areas that outperformed technology stocks over the prior three months. This shift is notable because information technology is by far the largest sector of the S&P 500, making up about 32% of the index, according to FactSet data. This underlines the growing strength of sectors like materials, which have traditionally been more cyclical and tied to the broader economy, as they began to surpass the tech sector’s performance.

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Despite its recent gains, the materials sector is still trading below its historical premium, according to BofA’s note. The strategists highlighted the sector’s price-to-earnings ratio relative to the S&P 500, which suggests that materials stocks may still be undervalued compared to other sectors, offering further room for growth.

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As the U.S. stock market kicked off the fourth quarter, it faced renewed challenges. On Tuesday, the S&P 500, Dow Jones Industrial Average, and tech-heavy Nasdaq Composite all closed lower. This decline followed an escalation in geopolitical tensions in the Middle East after Iran’s missile attack on Israel, which intensified concerns about the region's stability. The materials sector of the S&P 500 also experienced a slight downturn, closing 0.3% lower. In contrast, the information technology sector saw a sharp 2.7% drop, which weighed heavily on the broader S&P 500 index, leading it to end the trading session with a 0.9% decline.

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While short-term market fluctuations are inevitable, BofA’s bullish stance on the materials sector is rooted in a longer-term view. The strategists believe that the sector is poised for a strong rebound as interest rates continue to fall and global economic conditions improve, particularly with China’s stimulus measures and the potential for increased capital spending in manufacturing. With the materials sector already outperforming other areas of the market, this could be an opportune time for investors to consider increasing their exposure to this part of the economy.

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