Even with U.S. presidential election controversies still boiling, it’s not too early to think about potential equity investment opportunities as things simmer down.
Preliminary election results are pointing to a status quo Congress with Republicans holding the Senate majority by a slim margin, although control of the upper chamber could take until early January to sort out if two runoff races are necessary in Georgia. In the House of Representatives, Democrats are expected to retain control, albeit with a smaller majority.
We think three sectors are likely to be the most impacted by power dynamics on Capitol Hill: Energy, Health Care, and Financials.
Sector performance vs. the S&P 500
ALT = Performance of the Financials, Health Care, and Energy sectors relative to the S&P 500 since January 2020
Source - RBC Wealth Management, Bloomberg; data through 11/5/20
These sectors have been held back by election headwinds because market participants believed that all three would face challenges under a Blue Wave scenario. The thinking went that the fossil fuel industry would be confronted with a faster transition to greener energy sources and tougher regulatory schemes; segments of the Health Care sector—particularly pharmaceuticals—could face policy reforms that would constrain profits; and Financials could be vulnerable to additional regulations. In contrast, a gridlock scenario, in which control of government is divided between the political parties, would relieve pressure in these areas.
In addition to election-related worries, the Energy sector has underperformed the S&P 500 meaningfully (-51.1 percent vs. +8.7 percent year-to-date) because COVID-19’s economic gale force winds have kept crude oil prices relatively low. Financials have been constrained (-18.4 percent year-to-date) by the Federal Reserve’s ultra-low interest rate policies, which are also related to economic challenges.
If congressional gridlock plays out, and the U.S. economy and corporate profits continue to improve over the next year as we anticipate, we think these sectors have the potential to make up some of their lost ground.
Among the three sectors, we prefer Health Care and Financials for long-term investors, and view the Energy sector as being more appropriate for those with shorter time horizons and more tactical investment goals.
Health Care: Fundamentally sound
- The sector’s projected fundamental trends are solid. For 2021, earnings growth is estimated at 13 percent, more than double this year’s estimate, according to Refinitiv I/B/E/S.
- The sector’s price-to-earnings (P/E) ratio is roughly in line with its long-term average at 17.9x the forward consensus forecast. But its relative valuation compared to the S&P 500 is compelling, in our view. Health Care typically trades at a modest premium to the broader market, yet currently trades at a steep discount, as the S&P 500 P/E has pushed up to 25.3x.
- The S&P 500 Pharmaceuticals Index, with a forward P/E of 14.8x, is trading at a meaningful discount to its long-term average of 18.1x.
- The pharma segment should continue to benefit as COVID-19 treatments and vaccines are approved.
Financials: A better tomorrow
- We believe bank industry profitability reached its “low water mark” of this difficult economic and interest rate period in Q2 2020.
- RBC Capital Markets, LLC sees the potential for better stock price performance for banks. After the group reported Q3 earnings, analyst Gerard Cassidy wrote, “The expected earnings recovery from improved credit costs over the next 12 months should drive stock prices higher, similar to past cycles. Furthermore, should the yield curve continue to steepen into 2021, bank profitability could exceed most investors’ expectations leading to a further rise is equity prices and valuations, in our view.”
- We view bank stocks as attractively valued, assuming the economy continues to improve in 2021. The S&P 500 Banks Index trades at a price-to-book (P/B) ratio of just 0.91x, compared to a long-term average of 1.6x. While the ultra-low rate environment will likely keep the P/B from climbing back to normal anytime soon, we think yield curve steepening and further economic growth could shrink the gap.
- After a long period of restrictions on dividends following the global financial crisis, the Financials sector’s dividend yield has quietly crept back to its long-term average at 2.53 percent. The ratio of companies raising to lowering dividends in the last year is high, at 10:1.
Energy: A reprieve, not an all-clear
- We think the Energy sector’s business lobby will be particularly active in the next session of Congress, and has the potential to fend off key threats if Republicans maintain control of the Senate. RBC Capital Markets’ commodity strategy team wrote, “If Biden does prevail, he may have to scale back plans to remove subsidies for oil and gas producers because of congressional opposition.”
- But the reason we think the Energy sector is more appropriate for shorter-term, tactical investors than for those focused on long-term themes is that we don’t see the move toward green energy retreating anytime soon. If anything, it’s likely to gain momentum in the years ahead. Worldwide regulatory trends, especially aggressive green energy mandates and restrictions on fossil fuels in Europe, point in this direction. Also, should Biden win the presidency, his administration could implement some tighter energy regulations through administrative actions, according to RBC Capital Markets. Therefore, we think gridlock in the U.S. Congress would bring a reprieve for the Energy sector, rather than an outright all-clear signal.