Investment strategy Investing in the basic materials sector

The materials sector is made up of the raw materials that go into many products used by consumers and businesses. From the paper in your notebook to the plastic in your kitchen, basic materials are the building blocks of modern life.

Some of the most well-known materials in the sector are things like gold, silver, platinum, wood (lumber), iron ore, steel, as well as raw chemicals for industry and pharmaceutical use.

Understanding the basic materials sector

The basic materials sector of the economy is defined by the materials used in the production of almost everything we need to build. The wood that is used to build houses and the metals used to make the trucks that ship the lumber to a construction site are considered basic materials.

When many people throughout the economy have money to buy new houses, for example, the price of the materials used to build houses gets more expensive, and the companies that supply those materials make bigger profits, expand their operations and grow their businesses. The opposite is also true: when people stop spending money on new houses, whether because they lost their job, or they are afraid of not being able to save for the future, or the cost of borrowing to buy a new house is too high, companies in the basic materials sector will see profits fall and may have to scale back operations.

The materials sector can also be a hedge against inflation, because companies that produce basic materials are able to raise their prices in a growing economy without putting a dent in demand. On the other hand, if inflation is out of control or the economy contracts swiftly, demand could collapse and so could the dividends and share prices of basic materials sector companies.

Jonathan Linden, Executive Director at J.P. Morgan Private Bank, provided information on how the basic materials sector functions. “The materials sector is highly influenced by the combination of supply and demand. The pandemic was a crash course in learning all aspects of the cycle. Let’s take lumber, for example. As soon as the pandemic took hold, demand for most construction came to a standstill, leading lumber prices to fall approximately 45%. However, the desire for people to have their own living space catapulted at the same time that production of the material was halted, leading to demand massively outstripping supply. As a result, lumber prices increased 550% over the following 12 months.”

To top it off, Linden said, “Rising mortgage rates reduced the ability for many to purchase a new home while at the same time the world returned to normal and new supply of lumber was created. The commodity then fell nearly 80%, right back to where it was in 2019. While lumber serves as a case study, copper, steel, corn and aluminum prices all followed a similar trajectory. Bottom line, when demand is higher than supply, prices of the material and earnings for the companies that produce them will rise, often drastically. When supply is greater, the opposite occurs.”

How to get exposure to the basic materials sector

Linden noted there are some “secular” reasons that investors might want to look at the sector right now. “The last 10 years of low commodity prices has led to very little investment in new supply and consolidation of companies within the industry. Aggregate levels of demand have become stronger and are now starting to outpace supply, resulting in much higher commodity prices and earnings when compared to the last 10 years.”

“Additionally,” said Linden, “many materials – copper, aluminum, lithium – are considered ‘green metals.’ They are needed to transition the globe from fossil fuels to renewable forms of energy.”

Linden noted that engines in electric vehicles (EVs) use four times as much copper as the engine in a gas-powered vehicle. As a result, “the move to renewables should be good for companies exposed to these metals.”

The movement toward reshoring/onshoring, along with government investment (Infrastructure Investment and Jobs Act, Chips Act and the Inflation Reduction Act) is also beneficial for many of these companies. New construction of factories, plants, roads and bridges require materials such as cement and steel.

Investing in basic materials does come with risk. As mentioned above, rising inflation and rising interest rates may undermine consumers’ purchasing power, and that could take the steam out of an economic expansion. “Rising interest rates tend to cool the economy by slowing demand,” said Linden. “This often results in lower commodity prices which translate into lower earnings for many of these companies.”

The most direct way to get portfolio exposure to the sector is to own companies in that industry. Some of the industries with established companies include chemical companies, producers of chemical fertilizer, construction materials companies that produce paint, plastic piping and varnish, and paper and packaging companies. Metals and minerals miners are also staples of the basic materials sector.

In all, exchange-traded funds (ETFs) are a way to diversify your holdings in basic materials so you’re not tied to a particular company, or even a particular sub-sector. Before investing in the basic materials sector, connect with your advisor to see if it is a good fit for your portfolio.

Potential investment risks

As with all investments, investing in the basic materials sector does not come without risk. The materials sector is cyclical, meaning that related stocks tend to boom when the economy is booming and underperform when the economy is struggling. The value of materials themselves is highly volatile because they are closely tied to supply and demand. Therefore, materials stocks are volatile as well.

Due to their cyclical nature, investing in materials-adjacent stocks can offer high reward but also high risk. After the largest increase in Fed Funds rates in decades, higher interest rates have indeed slowed economic growth. If this were to eventually result in a recession, commodity prices and thus earnings could see an even greater drop as supply would far outpace demand from a cyclical perspective.

As always, reach out to a J.P. Morgan advisor with questions.