We didn’t get any nasty surprises Friday on inflation. In the current scenario, whereby inflation is moderating and the Federal Reserve is likely to lower interest rates, certain sectors of the stock market are poised to benefit more than others. Below, I examine five key sectors that investors should consider now.

But first, let’s look at the latest inflation numbers. Coming on the heels of April’s favorable consumer price index (CPI) data, Friday’s PCE report showed a welcome trend.

The U.S. Bureau of Economic Analysis (BEA) reported Friday that the personal consumption expenditures (PCE) price index at the “core” level (excluding food and energy costs) increased only 0.2% in April, in line with analyst expectations. On an annual basis, core PCE was up 2.8%, or 0.1 percentage point higher than the estimate.

Including the volatile food and energy category, PCE inflation was at 2.7% on an annual basis and 0.3% from a month ago. Both numbers were in line with estimates.

Fed officials prefer the PCE reading, which accounts for changes in consumer behavior such as substituting less expensive items for costlier alternatives. The core level is given particularly close scrutiny. The central bank looks for underlying long-term price trends that aren’t distorted by short-term “noise.”

A 1.2% increase in energy prices helped push up the headline PCE increase. Food prices posted a 0.2% decline on the month.

Goods prices rose 0.2% while services saw a 0.3% increase, continuing a normalization trend for an economy in which services and consumption provide much of the fuel.

Along with the inflation reading, Friday’s release included data about income and spending. Personal income climbed 0.3% on the month, in line with the estimate, while spending increased only 0.2%, below the 0.4% estimate and off March’s downwardly revised 0.7% (see chart).

Source: U.S. Bureau of Economic Analysis

Adjusted for inflation, the spending numbers showed a 0.1% decline, largely due to a 0.4% decline in spending on goods and only a 0.1% rise in services expenditures.

Moderating inflation, which increases the likelihood of the Fed cutting interest rates, leads to lower bond yields. This environment is favorable for equities, as lower bond yields drive investors towards stocks in search of higher returns. Additionally, lower interest rates can increase corporate profitability by reducing the cost of debt, further boosting stock prices.

At this juncture, here are the sectors you should be emphasizing:

• Technology

The technology sector often thrives in a low interest rate environment. Tech companies typically rely on borrowing to finance their rapid growth and innovation. Lower interest rates reduce their borrowing costs, allowing them to invest more in research and development.

Tech stocks are considered growth stocks, which tend to perform well when investors seek higher returns than what bonds can offer. That said, the “Magnificent Seven” mega-caps have gotten a bit pricey; consider innovative smaller companies with strong growth potential.

• Consumer Discretionary

The consumer discretionary sector includes companies that sell non-essential goods and services, such as entertainment, travel, and luxury items. Lower interest rates increase disposable income and reduce the cost of borrowing for consumers, leading to higher spending in this sector.

• Financials

The financial sector, particularly banks, can benefit from a moderating inflation environment in a couple of ways. While lower interest rates can compress net interest margins (the difference between what banks earn on loans and pay on deposits), they can also lead to increased borrowing and lending activity. Moreover, a stable economic environment reduces the risk of loan defaults. Investors should consider banks with strong balance sheets that offer diversified financial services.

• Real Estate

Real estate investment trusts (REITs) and other real estate-related stocks can perform well when interest rates are low. Lower borrowing costs make it cheaper to finance property purchases and development projects. Additionally, lower interest rates can increase property values, as real estate becomes a more attractive investment compared to bonds.

• Utilities

Utilities are typically seen as a safe, defensive investment. They offer steady dividends and are less sensitive to economic cycles. In a low-interest-rate environment, their high dividend yields become more attractive compared to the lower yields on bonds.

Manna in May…

The main U.S. stock market indices closed mostly higher Friday as follows:

• DJIA: +1.51%
• S&P 500: +0.80%
• NASDAQ: -0.01%
• Russell 2000: +0.66%

The benchmark 30-year U.S. Treasury yield ticked lower by 0.70%, to settle at 4.65%. The Dow Jones Industrial Average racked up its best trading session of the year.

Despite Friday’s sharp gains, it was a down week for the indices. The S&P 500 and NASDAQ this week snapped their five-week win streaks. But it was a winning month of May, with each of the major benchmarks posting a sixth consecutive positive month.

The upshot: Falling inflation is manna for stocks.

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John Persinos is the editorial director of Investing Daily.

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