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.

Lisa Shalett Chief Investment Officer, Wealth Management

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. 

Risk Considerations

Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 

Equity securities may fluctuate in response to news on companies, industries, market conditions and general economic environment.

Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate.

Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Rebalancing does not protect against a loss in declining financial markets.  There may be a potential tax implication with a rebalancing strategy.  Investors should consult with their tax advisor before implementing such a strategy.

Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies.  Technology stocks may be especially volatile.

International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies.

Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention.

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