Smaller recession risk suggests stronger cyclicals

Key takeaways:

• Technology companies have gone from massive underperformers to once again dominating equity markets.
• Year-to-date technology and the tech heavy consumer discretionary sector are up 32% and 39% respectively.

Russ Koesterich CFA, JD, Managing Director and Portfolio Manager discusses how improving economic expectations may suggest adding to cyclical areas of the market.

Like many trends that abruptly reversed in early 2023, technology companies have gone from massive underperformers to once again dominating equity markets. Year-to-date, technology and the tech heavy consumer discretionary sector are up 32% and 39% respectively (as measured by the respective S&P GICS sector index). This year’s performance is handily beating the market as well as trouncing last year’s winners, energy, and low-beta, defensive stocks.

That said, while tech companies continue to grind higher on a surge of enthusiasm for all things related to artificial intelligence (AI), relative performance has shifted. Recently many cyclical parts of the market, including the industrials sector, have outpaced the broader market as well as tech. This shift in leadership has coincided with a steady stream of better-than-expected economic data. As economic expectations improve, the equity rally has expanded to favor more cyclical companies. I would expect this trend to continue and would consider adding exposure to industrial stocks.

Recession fears subsiding

In contrast to earlier in the year, recession fears are abating and growth expectations rising. A Bloomberg consensus of 2023 U.S. gross domestic product (GDP) forecasts has growth at 1.3%, a significant improvement from January’s consensus of 0.5%. And although inflation estimates have started to slip, the consensus is still around 4%. Taken together, this suggests nominal GDP (NGDP) of 5% or more.

Nominal GDP matters as it is closely related to corporate earnings. If nominal GPD is likely to come in better than expected, earnings probably will as well. This shift would disproportionately benefit cyclical companies whose revenue is more closely linked to the economic cycle.

Not everything is expensive

Valuation is another factor favoring cyclicals. In aggregate, U.S. equities are trading at approximately 19x forward earnings, well above the historical average and a premium to most international markets. However, the premium is being driven by a relatively small number of stocks, mostly in technology and tech-related areas. Outside of these, most sectors, including industries, are trading at or below their long-term average (see Chart 1).

Global Sector valuation last 10-years

Apart from a stronger economy and cheaper valuations, many industrial companies, particularly in manufacturing and automation, stand to benefit from longer-term secular themes. Despite artificial intelligence having captured the public’s imagination, other innovations and trends may prove just as profound. A rapidly changing geopolitical landscape, pandemic induced supply concerns and a renewed focus on defense spending are driving generational shifts. For example, after decades of building increasingly complicated global supply chains, companies are now focusing on resilience rather than just cost. The net effect is a trend towards onshoring and ‘near-shoring’, i.e., locating manufacturing in adjacent and friendly countries.

What does this trend mean for broader portfolio positioning? While I still like tech and would maintain a long-term overweight, there are other opportunities that might justify a modest shift in positioning. A more resilient economy, reasonable valuations and a compelling set of long-term tailwinds suggest that it may be an opportune time to take some profits in tech and redirect to select industrials.

To obtain more information on the fund(s) including the Morningstar time period ratings and standardized average annual total returns as of the most recent calendar quarter and current month-end, please click on the fund tile.

The Morningstar Rating for funds, or "star rating," is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.