Cyclical stocks have been outperforming defensive stocks in this year’s market rally, with investors showing a preference for cyclical sectors in exchange-traded funds (ETFs). Goldman Sachs Group analysts believe that the majority of this cyclical rally has already occurred, noting that such sharp rotations are rare.
Since the start of May, U.S. cyclicals have risen by 18%, far surpassing the 2% increase seen in defensive stocks over the same three-month period. The analysts at Goldman Sachs attribute this to a “wide dispersion” at the sector level.
Among the cyclical groups, automobiles and components have performed exceptionally well, excluding commodities, with a gain of 53% during the three months through July. On the other hand, stocks in the consumer durables and apparel sector have experienced a decline of 1%, making them the worst performers in this category.
The future growth trajectory will determine if cyclicals can continue their strong performance. Historically, when growth decelerates after significant cyclical rallies, defensive stocks begin to outperform. Goldman Sachs’ economists forecast a deceleration in growth to 1.6% in the third quarter and 1.1% in the fourth quarter, which could affect the performance of cyclicals. The analysts caution that the recent rally may be pricing in an overly optimistic growth outlook of more than 2%, particularly considering the Federal Reserve’s focus on battling inflation, which could limit economic growth.
Despite these concerns, recent indicators of cooling inflation and low unemployment have prompted Goldman Sachs’ economists to lower their subjective probability of a recession in the next 12 months to 20%. However, it is important to note that meaningful improvement in economic data is necessary for cyclicals to continue outperforming following sharp rallies.
ETF Flows
During July, investors in equity ETFs showed a preference for cyclicals, indicating their willingness to take on more risk in the markets, according to Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors.
Equity ETFs see Strong Inflows
Equity ETFs have experienced robust growth in the past three months, with a total of $120 billion invested. According to a research note, this is the highest three-month total in 2023 and represents a significant rebound from earlier in the year.
Sector ETFs gain Momentum
In the same period, sector ETFs attracted $7.5 billion of inflows, marking the highest since October. Cyclical areas were particularly popular among investors, outpacing defensive sectors for the second consecutive month.
Cyclicals Drive Inflows
Cyclicals led the way in attracting investment, with nearly $8 billion flowing into these market exposures. This surge was mainly driven by the financial sector, as better-than-expected bank earnings repaired sentiment towards the industry after the mini-crisis earlier in the year.
U.S. Stocks Facing Decline
While the equity ETF market flourished, U.S. stocks faced a decline on Wednesday afternoon. The Dow Jones Industrial Average (DJIA) was down 0.9%, the S&P 500 (SPX) fell 1.3%, and the Nasdaq Composite (COMP) sank 2%. This negative trend was attributed to various factors, including the release of employment data and a downgrade in the U.S.’s credit rating.
Defensive Sectors Show Resilience
Despite the overall market slump, defensive sectors in the S&P 500 index held their ground. Consumer staples (XX:SP500.30) and utilities (XX:SP500.55) showed small gains, outperforming other sectors. However, the remaining 11 sectors experienced a decline in trading during Wednesday afternoon.
