Morgan Stanley
  • Wealth Management
  • Jun 8, 2020

As Sectors Rotate, Look Under Market’s Surface for New Leaders

Investors may not want to chase recent gains in the S&P 500. Instead, consider the cyclical sectors that are likely to benefit most from a potential V-shaped recovery.

U.S. stock market returns leveled off for about a month following the swift April rebound from the punishing March low. Since Memorial Day weekend, however, returns have surged once more. The S&P 500 is up 7% in the past two weeks and is now within 6% of its February all-time high. The strong May employment report was a recent catalyst—along with optimism over an earlier and smoother-than-feared national reopening of the economy and encouraging signs of resilience among consumers.

Now, rather than rush into the S&P 500, I suggest investors focus on underlying sectors that are likely to outperform that broad tech-dominated index. Already, market leadership is rotating to cyclical areas, like financials and basic materials, which are most likely to benefit from the V-shaped economic recovery that we believe is now more clearly underway. Here are four reasons cyclical sectors are likely to outperform the S&P going forward:

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  • The S&P 500 seems disconnected from the current economy. Stock valuation measures for the S&P 500 are very high. For example, the famous “Buffett Indicator,” which looks at total market capitalization relative to GDP, is currently at extremes last seen at the turn of the century. Alternatively, many cyclical sectors have very low relative valuations, due to concerns about global economic weakness.
  • Fed stimulus is leading to rising inflation expectations, which in turn leads to higher nominal rates. Since mid-March, a measure of future inflation, the 10-year breakeven rate, has increased to 1.22% from 0.5%. That has led to an increase in long-term interest rates. The yield curve, an important economic indicator based on the bond market, is starting to steepen, which signals investor expectations for economic growth ahead. The rise in longer-term interest rates tends not to support the growth stocks that dominate the S&P 500 index, but can be a positive for financials, which benefit when the difference between short term and long term interest rates widens.
  • The U.S. dollar is showing signs of weakening. Since late March, the U.S. Broad Trade-Weighted Dollar Index has fallen almost 5% from its peak. Gargantuan U.S. policy stimulus has been a significant positive, for sure.  But it comes at a long run cost of higher debts and deficits. The Federal Reserve is currently printing money to fund that and it debases the dollar as supply is greater than demand. Declines in the dollar relative to other currencies can fuel global growth, especially for emerging markets since it makes it easier for them to service their dollar-denominated debt. A weak dollar also helps U.S. exporters (since it makes U.S. goods cheaper for foreign buyers), but it creates headwinds for companies that import parts and materials for their supply chains, which includes many tech companies.
  • Growth could be broader-based in this cycle. The past business cycle was characterized by slow economic improvement, which caused investors to crowd into the few industries that showed strong growth—mainly technology and internet giants. The next cycle, is likely to be very different, impacted by fiscal stimulus which, unlike corporate tax cuts, flows to the real economy. This, combined with low interest rates, will likely lead to more spending in critical areas, like housing, that can generate growth in a wide assortment of sectors. 

As for the S&P 500 index, our assessment remains that it will be range-bound over the next three to six months. I see it capped on the high end by valuation constraints, the lack of solid visibility on earnings, COVID-19 developments and tenuous U.S.-China relations. On the low end, it will likely be supported by historic levels of monetary and fiscal stimulus.

The opportunity for investors, therefore, is in careful stock selection, as sector leadership rotates below the surface of the index.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from June 8, 2020, “V as in Sector Rotation.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.