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When Covid-19 and subsequent lockdowns arose, many businesses in energy, financials and industrials sectors bore the brunt of the economic freeze, due to lack of demand and the inability to operate normally, if at all.1 This prompted cyclicals to sell off, as capital was reallocated to areas like technology, which showed resilience or, in some cases, stood to benefit from the resulting change in lifestyle.2 But after headlines began to surface on promising vaccine candidates, cyclical names started to take in money once again.3 According to Markham, other factors, beyond news of the vaccines, are at play.
“I think the vaccines are only a catalyst for a situation that has been brewing. That’s the valuation differential between cyclical and secular growth sectors,” he says.
“Also, for the first time in many years, we have loosening fiscal policy at the same time as loose monetary policy.”
As concurrent looseness of fiscal and monetary policy has historically tended to induce a reflationary environment, cyclical stocks have a better chance of outperforming in the near term, according to Markham. In this type of environment, these names often tend to rise along with bond yields.4
As cyclical sectors continue to recover, money has been rotating out of secular growth names in defensive sectors like healthcare and consumer staples.5 The rotation is expected to disproportionately affect some sectors, and technology won’t necessarily be the biggest victim, according to Markham. Money has been flowing from healthcare,6 partially due to politically fuelled uncertainty, and consumer staples, which could see greater divestment because they do not boast high growth and lack comparable tailwinds to technology’s acceleration of adoption, he says.
“While money has been coming out of those two sectors, tech has gone into a treading water phase that I don’t think will last. We believe tech could resume outperforming since the amount of corporate spend on technology shows no sign of letting up, and in fact is accelerating,” he says.
“Over a 10-year period, we expect to see good performance from the tech sector. But in the near term, it may be that investors who made have made significant returns in those areas take some profits and allocate toward cyclical stocks.”
While technology’s success may be a long-term narrative, the current cyclical rotation is not expected to last throughout 2021, according to Markham. In fact, he believes a more persistent version of the reflationary trade may not take hold until perhaps 2022. Indeed, Markham adds there are likely to be headwinds for cyclical sectors once the current enthusiasm dies out.
“At some point, reality will kick in and government support programs will be lifted,” he says. “When that happens, the market might conclude those cyclical stocks that rallied may not be rewarded with higher earnings. And then, it will run back into the arms of some of those secular growth stories.”
Another headwind for some cyclical stocks includes possible irreversible effects to business operations. If not from a physical aspect, it could be that, psychologically, consumers aren’t ready to get back on planes and return to high-touch environments. Likewise, some may decide they don’t miss commuting to the office. Just as the pandemic accelerated certain trends, it may have created permanent lifestyle changes. These changes could become a secular headwind to cyclical winners of today, according to Markham.
Because of this, maintaining some exposure to defensive names may be warranted, he says. Particularly, defensive names that can participate in the cyclical rally:
“At this stage, within tech I would say hardware stocks are still cheaper,” Markham says. “They’re more cyclical so they can participate in these value rotations. But the basis for them is rooted in secular growth through increased digital exposure. You get access to both worlds with those names,” he says. “And over the long term, they could be more likely to be winners than some of the more traditional cyclicals which are now starting to lead the market.”
There are also companies within healthcare, notably the pharmaceutical industry, which have exposure to long-term growth drivers but are now priced more attractively thanks in part to the rotation, he says.
A balancing act
US markets tend to be technology oriented and offer more of a growth tilt, while Europe and Japan tend to be more value oriented.7 Specifically, in Germany, “they have a lot of old school industrial companies, which are classic cyclicals in this environment,” Markham says.
Looking ahead, he adds: “At the margin, there could be slight shift out of US equities and into continental Europe and Japan,” he says. “And if the reflationary environment results in a weaker US dollar, then the real trade to watch might be emerging markets, which could do well.”
Regardless, he is taking a balanced approach to ensure he can avoid periods of extreme swings in performance:
“We’ve kept a broad roster of names within the value-cyclical space, just to make sure the stock-specific risks are spread out. In a cyclical recovery, that can be a bit of a trap since all of those companies won’t benefit at the same time,” he concludes.
1 The Mercury News: a look at some of the hardest hist sectors in the S&P 500. March 15, 2020.
2 CNBC: The stay-at-home stocks surged as Texas paused reopening, Jim Cramer says. June 25, 2020.
3 Forbes: This is what you should know about the market rotation right now. November 16, 2020.
4 Yahoo Finance: Treasury yield spike risks sparking domino effect in markets. December 2, 2020.
5 Dow Jones Newswire: Tech down as rotation into cyclicals sectors continues. November 10, 2020.
6 CNBC: Three charts suggest more near-term weakness for healthcare stocks, analyst says. November 20, 2020.
7 Barron’s: Hunting for stock-market bargains? Look abroad. September 18, 2020.
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