Are declining cyclical stocks signaling upcoming changes in the global economic cycle?
Stock benchmarks across the globe are showing signs that leadership changes may be underway as stocks in beaten down defensive sectors are beginning to outpace stocks in cyclical sectors across Europe, Japan and emerging markets.
The trend is also evident in the U.S., where technology and consumer discretionary stocks had led the market for much of this year. But there’s been a shift toward utilities, telecom and consumer staples stocks, with these sectors outperforming the market leaders in recent weeks.
This past month, the consumer staples sector within the S&P 500 was the best performer, posting one-month returns of 4.15%, while the utilities sector was up 2.46%. Even the telecommunications services sector, which like consumer staples finished the second quarter down by nearly 10.00% or more from the beginning of the year, managed to stage a rally during June – gaining 2.24%, according to S&P Dow Jones Indices.
June was the first month “showing broad and consistent performance from the defensive sectors,” according to Morgan Stanley research cited in this CNBC report. “We think this is likely to continue and could portend a more difficult market environment overall as we enter the seasonally-worst time of the year,” said Michael Wilson, Morgan Stanley’s chief U.S. equity strategist. He noted that the S&P 500 typically trades poorly in July and August ahead of midterm elections.
The defensive sector universe generally includes consumer staples, energy, health care, telecommunications, and utilities, while cyclical sectors typically include consumer discretionary, financials, real estate, industrials, information technology and materials.
As the names suggest, cyclical stocks are viewed as being sensitive to the economic cycle which is reflected in growth in earnings and dividends, while defensive stocks are viewed as being able to provide stable dividends and earnings regardless of the maturity of the business cycle. A shift toward more defensive stocks is viewed by some market participants as early signals of turning points in business cycles.
The trend favoring defensive sectors in the U.S. has picked up even more steam since the final two weeks of the second quarter, according to prices on the S&P 500 sector indexes. Since June 18, the utilities sector is up 5.55%, telecoms have gained 3.74%, and consumer staples have risen by 3.19% through July 16. In contrast, industrials and financials have fallen by 1.93% and 0.07%, respectively. While the consumer discretionary and tech sectors were up by 0.76% and 0.44% during the same period, they haven’t been the outperformers that they have been for much of 2018.
Current Environment Favorable to Defensives?
Morgan Stanley recently downgraded other market leaders like small capitalization stocks to an underweight position from overweight. Small caps had been a strong performer as a safe haven from trade tensions, given the perception that smaller companies garner less revenues overseas. The firm also recently downgraded technology stocks to underweight from equal weight, noting that the risk is rising that tech and growth stocks in the U.S. will get “rained on,” as Wilson wrote in this July 13 research report.
“While we are not worried about an economic recession as the catalyst for underperformance in these market leaders like it was back in early 2016, we do think that the 2Q earnings season will bring an inevitable acknowledgement from companies that trade tensions increase the risk to forward earnings estimates, even if managements don’t formally lower the bar,” Wilson wrote.
A Look Overseas
Data from Morgan Stanley Capital International (MSCI) meanwhile shows that defensive stocks are outpacing cyclical stocks in emerging market nations, the eurozone and Japan. The trend has been notable in Japan for much of the year with the MSCI Japan Defensive Sectors Index up by 7.04% through July 13, while the MSCI Japan Cyclical Sectors Index is down 7.13%.
In the eurozone, both the MSCI EMU Cyclical Sectors Index and the MSCI EMU Defensive Sectors Index have been in negative territory for the year through July 13 – though defensive stocks are down by only 0.57%, compared to 4.63% for cyclical stocks. During the past two weeks through July 13, however, cyclicals have fallen by 1.36%, while defensive sector stocks are up by 2.25%.
Numbers don’t always tell the story as well as a picture. Or in this case – a chart.
According to Callum Thomas, head of research at Top Down Charts Limited, which compiled and published this chart below earlier this month, the chart shows the “previously strong cyclicals sector progressively rolling over across the major regions of the globe. Given this part of the market is typically at the crest of changes in the economic cycle it’s worth keeping front of mind, particularly as growth risks emerge,” Thomas said here.
(The chart shows the relative performance of cyclicals versus defensives as defined by MSCI with relative performance rebased to 1 as of mid-2015.)
Among the factors that could be causing such weakness, Thomas said: “Outside of the US we’ve seen economic sentiment indicators soften across the major economies, risk pricing indicators flare-up in Europe and emerging markets, and a significant rally in the U.S. dollar.
“Part of this is down to the turning of the tides in global monetary policy settings, but no doubt the trade war talk is also weighing and sometimes a simple lift in uncertainty can trigger off a feedback loop of slower activity and more uncertainty.”
Sources for Financial Data
S&P 500 Sector Indexes:
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