In mid-March, we called for cyclical equities to ourperform defensives over the medium-term. Using as proxies the Russell 3000 Dynamic and Defensives indices (our favorite barometers for these stock market cohorts), this pair trade was good for 187 bps of return over its life.
On June 2nd, we reversed course and called for a period of resurgence from defensives. In the three-and-a-half weeks that followed, less economically sensitive sectors mustered a 432 bps relative performance advantage over their cyclical counterparts, however, this advance proved short-lived, as cyclicals dominated in July, leading global equities meaningfully higher.
Importantly, while we did moderate our cyclical exposure somewhat, we warned our readers in the June note not to position for uber-bearish outcomes, as we expected relative gains over cyclicals to represent a last hurrah for defensives.
Our medium-term momentum model turned favorable toward cyclicals in July, and, at present, looks lead equities into Fall (or beyond). Accordingly, we are pulling the plug on our tactical bias in favor of defensives, for an 81 bps loss.
Moreover, a coming bottom in our long-term momentum indicator seems to point to a reversal of the year-long period of outperformance by cyclical equities.
An examination of correlations of six month changes in domestic Industrial Production with six month price returns for each of the ten S&P 500 sectors (since September 1989) identifies Industrials (0.62), Financials (0.56), Information Technology (0.53) and Energy (0.52) as the most cyclically dependent equity sectors. Of these, the momentum backdrop is outright bullish for the IT sector.
The chart below illustrates monthly momentum for the most cyclical equity sectors relative to the broad market (based on MSCI ACWI). Notice that the momentum curve for the Technology sector recently bottomed and appears poised to improve into next year.
Momentum for Industrials seems set to roll over this Fall, however, we note there is currently no indication that this measure will breach zero. As such, while this gauge conveys less than maximum bullishness for Industrials, we do not judge the outperformance trend in effect since the Summer of 2015 to be in jeopardy.
Long-term momentum for Energy is expected to rise into next year, however, the weak trajectory (specifically, the expectation that the relative the momentum curve will fall short of the zero threshold) warrants some level of skepticism.
And finally, our conviction in the ability of Financials outperform is scant, as a result of monthly momentum’s recent failure at the zero line and current downward bias. A bottom does not appear to be in the cards until around year-end. We do note though that shorter-term momentum measures are supportive of outperformance potential. In fact, on the back of improving daily and weekly relative momentum, the MSCI ACWI Financials Sector fared 51 bps better than the broad index in July (on a price-only basis). Continued outperformance over the medium-term could engender greater confidence in the longer-term prospects for the Financials sector (a continued strong showing from Financials should coincide with rising interest rates at the long end of the curve).
Separately, small cap equity returns have likewise demonstated a strong direct historical correlation with cyclical outperformance (0.58). That our monthly momentum work also favors small company shares to beat the market fits with our preference for cyclical equity exposure.