Why the cyclical rally can continue

Russ discusses how to navigate the rally in cyclical stocks.

Stocks have been rangebound in recent weeks. While economic data continues to evidence a strong recovery, rising rates have constrained markets, particularly the technology sector. That said, cyclicals continue to outperform the broader market. Year-to-date, energy, materials, industrials and financials all continue to lead the market. As I discussed back in November, cyclical leadership is likely to continue, both at the sector and sub-sector level.

To see why look no further than U.S. households. The vaccine rollout is accelerating just as U.S. households are flush with cash. Thanks to unprecedented fiscal stimulus the savings rate has surged to more than 20%, nearly triple the pre-pandemic level. And this is before another round of stimulus checks hits checking accounts.

Not only has the savings rate surged but wealth has also hit a peak, a highly unusual development immediately following a recession. A surging stock market and a well-bid housing market have conspired to push household net worth to $130 trillion, a 10% increase compared to Q4 2019 (see Chart 1).

U.S. household net worth

Struggling to keep up

Household spending has the potential to go parabolic at a time when manufacturing is already struggling to keep up with demand. The ISM New Orders Index has remained above 60 for eight straight months, the longest stretch in more than three years. New orders relative to inventory, a good metric for demand relative to supply, is roughly double where it was last spring and about 30% above pre-pandemic levels. Even in Europe, where the vaccine rollout has been slower and fiscal stimulus less generous, March manufacturing surveys surged well above expectations.

Flush consumers and pressed-upon manufacturers are causing temporary bottlenecks, an issue highlighted in a recent note by the BlackRock Investment Institute. Although semiconductor shortages have been the most cited constraint, the issue goes beyond computer chips. At least in the near term, manufacturers should enjoy unusually strong pricing power.

Look beyond industrials and materials 

With demand high and supply constrained, traditional cyclicals are experiencing the strongest rebound in earnings. And unlike in 2020, it is earnings rather than multiple expansion driving stocks. For these reasons I would overweight cyclicals but with a continued focus on high quality companies, i.e. companies that are more profitable and consistent than their peers. While it’s true that many low-quality names have led the rally since the November vaccine news, this trend appears to be waning. Going forward I would focus on quality names.

More specifically, I would not limit cyclical exposure to industrials or materials. Although I see opportunities in these sectors, I’d also add to tech expressions, specifically semiconductors, semi-cap equipment and payment companies. Also consider financials, particularly banks and consumer finance companies geared to spending. Finally, I would lean into direct consumer plays, such as home builders and select apparel. While it won’t last, we are likely on the cusp of a surge in demand; investors will want to take full advantage of this unusual alignment.