Cyclicals yes, junk no

Russ Koesterich, CFA, JD |Aug 27, 2020

Cyclicals are starting to have their day. After being trounced by secular growth stocks, notably technology, during both the sell-off and subsequent rebound, the more economically sensitive parts of the market are outperforming, with sectors like industrials easily beating the market during the past month.

This rebound has occurred against a backdrop of better-than-expected economic data and a pulse in the value trade. But for investors the lesson here is to be discerning. A recovering economy supports cyclicals but beware of low quality and secularly impaired value stocks.

Not good, but better-than-expected

There are two main arguments for rotating into cyclicals: The economy is doing much better than many feared and much of the cyclical segment is playing catch-up after dramatically underperforming earlier in the year.

Starting with the economy, both the global and U.S. economy are healing in a meaningful way. And while it is fair to highlight that the improvement is only stellar relative to the most violent contraction since the Great Depression, the pace of economic gains is beating even the most optimistic forecasts.

In recent months economic data has been exceeding expectations by the largest margin in at least a decade. Nor is this simply a U.S. phenomenon. The same pattern holds in Europe (see Chart 1). And while economic scars remain and unemployment is stuck at recessionary levels, jobs are returning surprisingly quickly.

Economic Surprise indices

Economic surprise indices

Source: Bloomberg, as of August 16, 2020.

The economic improvement provides a catalyst for cyclicals to start closing the historically wide performance gap with growth. Even after leading the past month, outside of consumer discretionary stocks, most cyclicals sectors are dramatically underperforming. Year-to-date the S&P 500 is now up +6% and Nasdaq more than +20%. By contrast industrials are off -4%, financials -17% and energy more than -30%, even after a 45% rally off the lows.

High quality cyclical, not low-quality value

Here it is important to note that adding to cyclicals is not the same as chasing deep value. Given the heavy weighting of cyclicals in most value indices, many investors conflate the two. While I’m comfortable increasing cyclical exposure I would remain leery of piling into value. Be cautious with businesses, such as integrated oil or department stores, facing secular headwinds.

Where does that leave investors? Emphasize niche areas with long-term pricing power. A few examples include rails, specialty chemicals and manufacturing companies geared to low inventory levels.  Also, stick with high quality names. Capital goods and much of transport score high on metrics such as earnings consistency and profitability.

Another way to play the cyclical theme: Emphasize the intersection between cyclical and secular growth, i.e. semiconductors.

To be clear, there is a time to buy junk. Typically, it’s been when pessimism is at its worst and valuations their cheapest. Today is not that time. The economy is healing; investors want to take advantage of this by owning marginally more cyclicals. They just need to make sure they own companies that can survive the next downturn.

Russ Koesterich
Portfolio Manager
Russ Koesterich, CFA, is a Portfolio Manager for BlackRock's Global Allocation Fund and is a regular contributor to The Blog.