Key Takeaways
- The materials sector tends to be closely tied to the economic cycle—rising and falling with the overall state of economic growth.
- In the past year, the sector delivered positive but sluggish returns, reflecting concerns over recession risk.
- However, historically the sector has performed well in the early stages of new economic growth, and so could be well positioned for any eventual economic recovery.
- I have found long-term investment potential in a number of segments of the sector that have shown favorable supply-and-demand dynamics, including among copper miners and US chemical manufacturers.
Many forces and drivers impact the materials sector. But over the past year or so, one driver has been preeminent: the state of the economy.
As a cyclical sector, materials stocks tend to rise and fall with the broader economy. And with the economy seemingly perched on the precipice of recession for more than a year, materials stocks have not been in favor.
However, the economic cycle will inevitably continue to evolve in 2024. Any eventual economic brightening could act as a catalyst for the stocks. And favorable supply-demand dynamics in some areas of the sector could set up a constructive outlook for the year ahead.
A positive, but slow, past year
The materials sector encompasses industries such as chemical producers (including makers of fertilizers and industrial chemicals), metals producers (including gold and copper miners and steelmakers), makers of construction materials (such as cement, bricks, glass, and gravel), and producers of wood-based goods (such as lumber and paper packaging). These industries operate in global markets, and demand for these goods tends to be highly dependent on the state of the broader economy. For example, construction materials are likely to be in higher demand when the economy is booming. For that reason, materials are inherently a cyclical sector, meaning they tend to move in sync with the economy.
In 2023, the sector's performance reflected this close relationship. Like the broader economy, the materials sector still eked out positive growth. But like the broader economy, the sector's performance was sluggish—hampered by investor concerns over recession risk.
Past performance is no guarantee of future results. Materials sector performance is represented by the S&P Materials Select Sector index. Data as of December 8, 2023. Source: S&P Dow Jones Indices, a division of S&P Global.
While the sector lagged the double-digit returns of the S&P 500®, it's important to remember that the S&P's gains were disproportionately driven by a handful of mega-cap growth stocks—particularly companies in the technology and communication services sectors that were seen as plays on the rise of artificial intelligence. Amid such narrow leadership, materials simply didn't shine.
Looking beyond short-term economic sensitivity
For 2024, the sector's performance may continue to be driven primarily by macroeconomic issues. And to be sure, if a recession finally materializes, it could weigh on the stocks over the short term. But eventually a new cycle of economic growth is likely to emerge—whether after a recession or after a so-called "soft landing"—which could benefit materials stocks.
I focus on finding areas of the sector with the most attractive supply-and-demand dynamics, and establishing fairly concentrated positions in those areas with an overweight in copper producers, while avoiding investments in lithium miners. This may seem counterintuitive, because both of those metals are key inputs in the development of electric vehicles, and both are expected to see strong demand growth in the coming years from the long-term transition to EVs.
The difference between the two, in my view, is in their respective supply profiles. Copper supply has been challenged for some time now, and could become increasingly tight in the years ahead. Copper mines are aging, and the quality of the ore produced has been decreasing in key producing countries like Chile and Peru. Although demand for copper dipped a bit this past year due to China's economic headwinds, I believe that an eventual pickup in demand could trigger a rally in copper prices, because supply will be tight.
By contrast, there is really no shortage of lithium, and there are new industry entrants that will likely further increase supply going forward. So even if demand grows as expected, I don't believe the long-term picture for commodity prices is as attractive for lithium as it is for copper.
Potential opportunities in chemicals and gasses
Elsewhere in the sector, I've recently identified opportunities in a group of US chemicals companies, particularly within the commodity chemicals segment. These are chemicals made on a large scale and used to produce other chemicals, which, in turn, are used to produce a range of end-user products, including construction materials, adhesives, plastics, and more.
Many of the US firms in the segment employ natural gas in their manufacturing processes, which gives them a cost advantage over their European counterparts, who use oil. US energy prices are generally lower than those in Europe, and this difference is even greater when comparing US natural gas to European oil. These cost advantages have translated into pricing advantages for US companies, which I believe could help this group gain market share and sales.
Lastly, while I tend to focus on stocks I believe are poised to benefit from the economic cycle, I also try to maintain stability in the portfolio via steady, non-cyclical companies, as long as they are in what I consider to be improving end markets. There may be momentum on global energy transition trends, particularly in the area of carbon capture.
Focusing on stocks with favorable supply-demand profiles
Materials stocks could remain in a holding pattern until the Fed and other central banks end their rate-hiking cycles and start lowering interest rates.
While I can't control what the Fed or the economy will do, I aim to invest for the eventual upturn in the economic cycle that may occur if or when rate cuts begin. Some materials stocks have traded at depressed valuations, and establishing or adding to holdings in well-positioned companies at inexpensive prices in recent months could prove beneficial. I may continue to seek areas of the sector that I believe have the strongest supply-and-demand profiles, and which I believe could respond well to a growth rebound.