Market zeitgeist turns towards cyclical stocks

Fiscal stimulus measures, if they come, point to a broader rally in equities.

  • By Michael Mackenzie,
  • Financial Times
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Investors are looking beyond the political posturing in Washington and counting on another surge in government spending.

A sustainable economic recovery that facilitates a broader equity rally requires comprehensive fiscal solutions, rather than just relying on another decade of ultra-low interest rates.

If they come, the fiscal stimulus measures are likely to reshape equity markets with greater interest in sectors that have been overshadowed by the tech sector juggernaut of recent years. There might well be more investor opportunities in smaller to medium sized companies and in the materials, industrial and financial sectors.

Understandably, the Covid-19 pandemic story in equities early in the year was selective given the scale of the economic shock, mainly rewarding technology titans and quality companies with robust business models.

Earnings growth in the coming quarters may well vindicate current valuations for those high flyers, but from such lofty levels, expectations for further upside appear tougher.

Since mid-May, there has already been a big rebound in global and US industrial companies. They have beaten both their respective broader markets and technology sector rivals.

US industrials have gained 35 per cent versus a 21 per cent rise in the S&P 500 during this period, a sharp divergence that, in the past, has signalled the start of a new business cycle. The group remains slightly down on the year, with gains for transport companies offset by falls in airline stocks.

US small and midsized companies have also lately eclipsed the performance of larger rivals — often a sign that a broader rally is afoot. This trend has room to run. As Bank of America notes, shares in small companies trade at their biggest discount versus those of larger companies in two decades.

Nicholas Colas at DataTrek Research argues that “a global recovery is just starting” and “should provide the sort of earnings leverage that powers higher stock prices” for industrials.

More investors are paying attention. Tobias Levkovich and the US equity team at Citi relate how recent feedback from clients that underscores a shift in the “zeitgeist” towards industrials, materials and financials heading into 2021, and a move away from the favouring of technology seen in 2020.

Much now depends, though, on the ultimate business damage inflicted by the pandemic and, more importantly, the extent of fiscal policy beyond current support measures.

Additional government spending efforts at this juncture are clearly required to prevent the nascent recovery in economic activity stalling before the end of the year. A cloudier economic horizon beckons with Covid-19 restrictions increasing in many countries. Meanwhile, the prospect of a vaccine appears to be a story for next year.

Christine Lagarde of the European Central Bank this week expressed concern about a “cliff effect” if fiscal support is withdrawn too soon, while Jay Powell at the Federal Reserve thinks the “risk of overdoing” stimulus is smaller than not doing enough.

Clearly, they are not alone in thinking that there are grounds for a much bigger fiscal deployment. Hence the recent enthusiasm in some market circles for a blue wave sweep at next month’s US election, whereby the Democratic Party claims the White House and Congress.

“There is a growing appreciation that more stimulus is needed and a recognition that it arrives through a unified government,” said John Normand, JPMorgan’s head of cross market strategy.

Many industrial companies could also benefit from expectations of a more pronounced shift in government spending towards infrastructure, green projects, and better research funding as part of a new technology race between the US and China. While cautious on the overall economic horizon, Pimco’s latest secular investment outlook describes these factors as potential “positive longer-term growth scenarios”.

Still, industrials and other cyclical stocks will remain highly sensitive to economic swings. A rising tide of government debt that is being bought by central banks also rightly worries many investors. Excessive debt loads can weigh heavily on the long term performance of an economy. Any fiscal spending needs to boost productivity.

Given the difficult economic backdrop, Pimco expects repeated bouts of financial market volatility. With interest rates in advanced economies cut to the bone, the influence of central banks on markets might be less than in recent years.

“We see little reason to be confident that the pattern we have observed in the past 10 years of ‘bad news is good news’ — where markets anticipated central bank responses that dominated macroeconomic realities — will continue,” says Pimco in its outlook. “Over the next three to five years it is quite likely that bad news on the macroeconomic front will turn out to be bad news for risk assets.”

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