Morgan Stanley
  • Wealth Management
  • Feb 10, 2020

Why Cyclical Stocks Are Worth Considering Now

Sectors tied to an economic recovery, such as industrials, energy and financials, may be underpriced as investors ignore the potential for global reflation.

The latest data suggest that the global economy may be turning the corner, fueled by accommodative central bank policy and easing of U.S.-China trade tensions. Concern about growth due to the coronavirus outbreak did recently spark a selloff in global markets, including the U.S., but the S&P 500 Index has so far recovered—and then some.

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While some investors may be celebrating new highs, I see some risks ahead. Corporate profits have been roughly flat for the past year, rendering the S&P 500 very expensive on a price-earnings basis. Its P/E is now above 19. That’s within the top 10% of the past 100 years.

That’s not the only problem. It’s clear that investors continue to favor U.S. secular growth stocks, especially large-capitalization technology names that can continue to grow even if the economy doesn’t. They also favor defensive sectors, such as consumer staples and utilities, over cyclical sectors, such as financials, industrials, energy and commodities, which are linked to economic growth.

Such market behavior suggests that investors don’t believe economic growth is improving, but rather that they expect the “Goldilocks” economy—not too hot, not too cold—to continue for the foreseeable future. They expect inflation to remain muted and seem confident the Federal Reserve will keep interest rates low and markets liquid.

They could be wrong.

I haven’t given up on the global reflation scenario that we outlined in our 2020 Outlook. I continue to believe last year’s synchronized monetary stimulus will be effective at recharging the global business cycle and reviving corporate spending.

If that happens, the rate of inflation could start to rise, indicating the Federal Reserve may have made a policy mistake. The Fed’s response could be to hike interest rates, not cut them further, which many investors expect. At that point, investors could move out of expensive secular growth stocks and into cyclical sectors that now seem inexpensive.

I suggest investors consider scaling back on high-priced growth stocks or passive investments in the S&P 500 and reallocate into cyclical sectors that would be poised to do well in a reflation scenario.

Today’s lower interest rates mean companies are dealing with a lower cost of capital, which should encourage more capital spending. Already, we’re starting to see a pickup in new order rates, which has typically preceded performance gains for economically sensitive companies. Even a small increase in capital spending could lead to a rebound for cyclicals.

Plus, I’m concerned that the Fed may be keeping rates low for too long, potentially allowing a bubble in asset prices to develop. If inflation and interest rates surprise to the upside, cyclical sectors may be some of the only areas in U.S. markets priced to handle the risks of a policy mistake.