An inflation-fighting Fed is a new experience for most investors. Here's how to play it

Published Sun, Jan 30 20229:09 AM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

For many investors, a period of sharply rising prices and an inflation-fighting Federal Reserve is unchartered territory. But market pros say there are plenty of stocks that do well in this kind of environment, it's just more difficult to find the winners than it has been recently. Investors haven't been challenged with a period of such hot inflation since the 1970s and 1980s. The Fed is taking its inflation fighting role seriously and last Wednesday said it could soon start raising interest rates. Fed Chairman Jerome Powell, who had once called inflation "transitory," acknowledged there were risks inflation could still go higher and be more persistent than expected. Powell suggested the Fed could be even more aggressive with interest rate hikes than the four the market had expected this year, starting in March. As a result, market expectations shifted to five rate hikes , and economists also changed their outlooks. Bank of America economists say there could even be seven quarter point rate hikes this year. Corporate profits have been a bright spot for the market post-pandemic, and strategists say they need to continue to strengthen to keep stocks moving higher, beyond the current turbulence. One place they can add to profitability is through margins. So unless companies can raise prices in response to higher wages, energy and goods costs, they could suffer from shrinking profitability. The cost of money will also rise with higher interest rates, so some of the stocks that were looked to for potential growth in the future, like tech and high-growth names, have been instead looking to be too high-priced. "I like cyclical sectors because we're moving into this inflationary regime. In a reflationary regime, financials trade pretty well, and materials, and energy," said Barry Knapp, director research at Ironsides Macroeconomics. Energy and financials have been standouts so far this year, in the January sell-off. The energy sector is the only positive of the major sectors, and the financial sector is down less than 1%. The Energy Select SPDR ETF i s up 18.3% so far this year, while the S & P Financial Select SPDR Fund ETF is down 0.8%. The Industrial Select Sector SPDR ETF is down 5.8%, and the Materials select Sector SPDR is off 8.2%. "I think the health care sector is interesting but for different reasons. They've seen margins falling for 30 years," said Knapp. He added the sector is making improvements with technology, becoming more efficient and streamlining costs. The Health Care Select Sector SPDR Fund was down 7.4% since the start of the year, and the Technology Select Sector SPDR Fund ETF is off 9.1%, one of the worst performers of the major sectors. The worst performer was consumer discretionary, with the Consumer Discretionary Select Sector SPDR Fund down 12.9% for January. The S & P 500cn is down 7% for the year so far, while Nasdaq is down 12%. Some high flying stocks, like those in the Ark Innovation Fund are down much more. That fund, for instance, is down 27% since the start of the year and has been a poster child for the decline in high-flying stocks. The major sector with the best profit margins is technology, at an expected 25% in 2022, compared to what is expected to be a record 12.6% profit margin for S & P 500 companies overall, according to Goldman Sachs. Goldman expects industrials, materials and energy to all see margin expansion, and the firm said those sectors, along with financials, typically outperform when interest rates are rising. "Tech was a huge winner in the 1990s and then a market performer in the 2000s. They were huge winners in the 2010s, as they built out the cloud and digitization, and now they're market performers," Knapp said. But winners now could be the companies that are employing digitization and cloud services, and that should help margins in other industries. "We'll see it broaden out into financial services, health care and we'll see it broaden out into industrial manufacturing," Knapp said. Strategists say investors need to beware when looking at sectors because individual companies within an industry group can diverge widely when it comes to margin growth. Julian Emanuel, Evercore ISI chief equity, derivative and quantitative strategist, said investors are now laser focused on margins and whether companies are able to control costs or raise prices. In a recent note, Evercore pointed to two big banks with very different stories. On earnings day for JPMorgan Chase, its stock fell sharply after it discussed rising costs. Wells Fargo , on the other hand, gained with its costs in line, the firm noted. Evercore strategists looked at a range of companies with upcoming earnings reports, and noted that both Pultegroup and D.R. Horton , which report this week, could be margin "beneficiaries." The Evercore report noted that Pulte has said it has opportunity to further expand its margins based on a limited supply of homes, strong demand, price and lower lumber costs. United Parcel Servic e reports Tuesday, and it has said it is managing rising labor costs, the report noted. Eaton reports this week, and it has noted margin improvements. Parker-Hannifin, reporting Feb. 11 and Masco, reporting Feb. 8, both reported margin expansion. Companies that Evercore termed margin "stressors" include Kellogg which reports Feb. 10. It has discussed challenges from rising costs, as has Clorox, which reports Thursday. Sealed Air reports Feb. 17 and has said it was feeling margin pressure.

Traders on the floor of the NYSE, Jan. 24, 2022.

Source: NYSE