The Cyclical Rebound

Cyclicals Leading the Way

Last week energy and materials led markets with gains of 3.74% and 1.51%, respectively. Within the last month, both of these industries have also led, with the energy sector (XLE) up over 7% and materials sector (XLB) up nearly 6.5%. This is consistent with the broadening-out theme we have been highlighting. Over the last month, the S&P 500 equal weight index has outperformed the market capitalization weighted index by approximately 20 bps.[1]

Chart 1: Energy and Materials Have Outperformed Technology in the Last Month[2]

With global interest rates projected to decline later this year coupled with economic stability, the most cyclical industries are seeing a turnaround. Last Tuesday, Jamie Dimon referred to the U.S. economy as “kind of booming,” referencing record-low unemployment and rising wages. We agree and believe the Fed has room to keep interest rates higher for longer without damaging the economy. Fitch Ratings also increased its 2024 global GDP forecast to 2.4%, improving its outlook for the U.S. by 0.9 pp and emerging markets 0.1 pp.[3] Investors are beginning to see the resiliency of the U.S. economy which is spurring sector rotation.

Fundamentals Support the Narrative

The rotation into sectors with greater cyclicality is not only because of overbought conditions in technology, but also because these sectors have experienced strong fundamentals. For the fourth quarter of 2023, the energy sector experienced a positive earnings surprise of 10.7%, relative to the information technology sector’s positive surprise of 6.2%. Utilities saw 32.1% y/y earnings growth in the fourth quarter, with technology seeing 23% growth. Looking ahead, utilities lead all sectors with an earnings growth estimate for Q1 2024 of 23.6% y/y, relative to the S&P 500’s expected 3.3% growth.

Commodity Prices on the Rise

The International Energy Agency (IEA) released last week that U.S. crude oil production is projected to increase to 13.19 million barrels per day this year, up from earlier projections of 13.1 million.[4] This is the fourth time since November that the IEA has raised its view on oil demand growth. This comes as OPEC+ extended its supply restraint of 2.2 million barrels per day earlier this month until the end of June to support prices amid growth concerns. Although demand is down from last year, overall oil consumption is trending back to its historical average and pre-pandemic levels. Tight supply and rising demand are supporting price increases, with brent and crude oil futures both up over 10% to start the year.

In terms of refined products, for the week ending March 8, 2024, refineries operated at 86.6% of their capacity. This is below their long-term average of 89.61%, but above recent lows in early February, near 80%. In the same period, gasoline inventories fell by 5.7 million barrels, almost triple the expected decrease of 1.9 million barrels. With low supply heading into the spring/summer season, gasoline prices could rise going forward.

Earlier this January, Valero Energy (VLO) mentioned during its earnings call that it expects refinery margins to remain supported by tight product supply and demand balances. VLO is a downstream petroleum company in the business of manufacturing and marketing transportation fuels. Management was optimistic about demand going into the spring and summer driving months. It mentioned jet demand was down last year around 10% from pre-Covid levels but is expected to close half of that gap this year. Total air travel in 2023 was up 37% compared to 2022 and was 94% of pre-pandemic total volume.[5] For the week ending March 8, jet fuel product supplied was up 2% compared to the same four-week period the previous year.

The Metal of Electrification

Besides energy, copper prices are at 11-month highs amid news of production cuts in China, which is the world’s leading refined copper producer and consumer. Top smelters in the country agreed to cut production last week as their fees earned from producing copper have declined nearly 76% in two months.[6] No agreement on the volume of cutbacks was made, but production output cuts will be decided at the discretion of each individual smelter.

Amid the energy transition into greener forms of fuel, copper has been dubbed “the metal of electrification.” Copper has the highest conductivity of any non-precious metal and has become an integral material in the production of emerging technologies. Electric vehicles need approximately 2.5 times more copper than conventional cars,[7] but the supply gap will need to greatly improve to meet this level of demand. Global copper demand is projected to grow from 25 million metric tons today to nearly 50 million metric tons by 2035, with energy transition technologies making up half of the growth in demand. With that said, copper mine production was estimated to be around 22 million metric tons in 2023.

Chart 2: Growth in Copper Demand Set to Double by 2035[8]

More Technology, More Energy

A second derivative stemming from the AI wave is the amount of energy needed to support technological advancements. According to the IEA, electricity consumption from data centers, AI and cryptocurrency could double over the next three years. The 2022 consumption level of 460 terawatt-hours of electricity is expected to reach more than 1,000 terawatt-hours in 2026 – roughly equivalent to the total electricity consumption in all of Japan.[9] Moreover, billions of gallons of water are needed to cool data centers. In 2022, Google’s data centers consumed 5 billion gallons of water for cooling, up 20% from 2021.[10]

With over 5,000 data centers operating in the U.S. as of today, this number is expected to see exponential growth through the acceptance of AI and emerging technologies. According to McKinsey, data center demand is forecast to grow 10% a year until 2030. On top of that, global spending on the construction of data centers is forecast to reach $49 billion by 2030. Energy production around the world will need to see the same investment and growth in supply to meet expected demand. Whether by fossil fuels (such as coal and natural gas) to produce electricity, copper in the production of new electronics or water to cool data centers, energy use will need to be ramped up in the coming years.

Chart 3: Data Center Power Consumption Through 2030[11]

[1] Source: FactSet. As of March 19, 2024.

[2] Source: FactSet. As of March 15, 2024.

[3] Source: Fitchratings. As of March 13,2024.

[4] Source: Bloomberg. As of March 12, 2024.

[5] Source: IATA. As of January 31, 2024.

[6] Source: Reuters. As of March 14, 2024.

[7] Source: IEA. As of May 5, 2021.

[8] Source: S&P Global. As of July 2022.

[9] Source: IEA. As of January 2024.

[10] Source: e360.yale.edu. As of February 6, 2024.

[11] Source: Mckinsey. As of January 17, 2023.