What to make of the cyclical rotation

06 March 2023

Dorothée Deck, Cross Asset Strategist

Key points

  • Equity markets have rallied strongly from their October lows following better-than-expected economic growth and cooling inflation – with cyclical sectors outperforming defensive ones
  • Fixed income markets are now pricing in US rate cuts towards the end of the year, or beginning of 2024, while equity markets appear to be discounting a soft economic landing
  • Such optimism seems premature and we remain sceptical of the sustainability of the equity rally. Until there is clear evidence that the worst of the economic slowdown is over and that rates have peaked, consolidation at the index level seems more likely  
  • This article puts the recent rally into an historical context, highlighting areas of the market that have lagged their historical relationship with economic activity. It also considers whether these apparent disconnects represent potential investment opportunities, or whether they are fundamentally justified

Risk assets, and equities in particular, have rallied strongly from their October lows, on the back of an improving growth and inflation outlook. While the performance of global equities, as an asset class, appears to be consistent with the current level of economic activity, the relative performance of cyclicals against defensives has overshot its historical relationship with the business cycle. Does this disconnect point to a potential investment opportunity, or it is fundamentally justified?

In recent months, economic growth has been stronger than anticipated while inflation has cooled faster than expected. This has triggered powerful rallies in risk assets, with global equity markets now pricing in a soft landing for the economy, as opposed to a mild recession back in October. The sustainability of this rally remains unknown, and until there is clear evidence that activity has troughed and rates have peaked, consolidation at the index level is more likely. 

In the meantime, and following the substantial moves in asset prices in the past four months, this article looks under the surface and attempts to identify areas of the equity market that appear mispriced and could represent attractive investment opportunities. 

The article also takes a step back from the current uncertainty and puts the rally in risk assets into an historical context. It highlights pockets of the equity market which appear to have lagged their historical relationship with trends in economic activity. 

It also discusses potential reasons why that might be the case, and whether those areas represent attractive investment opportunities or, instead, only reflect their vulnerability in a world where rates are likely to be higher for longer.

Historically, troughs in the ISM manufacturing index have been followed by powerful rallies in risk assets  

Performance across assets 

Global equities have returned 32% on average in the year following a trough in the ISM manufacturing index, outperforming US 10-year treasuries by 26%, based on data since 1975 (see chart). Asia ex Japan and UK equities generally outperformed those in Japan, the eurozone and the US.


Commodities also had a strong run, up 18% on average, led by oil (+40%) and copper (+22%), while gold made more modest gains (+4%). Meanwhile, US high yield credit outperformed investment grade by a large margin (up +21% vs +10%, respectively). The US dollar was broadly flat against its major trading partners.  

Performance of equities   

Equities generally troughed one month before the bottom in the ISM index, both in the US and Europe. They performed strongly in the year following a trough, but below average in the subsequent year. The S&P 500 returned 30%, on average, in the first year and 6% in the second year (see chart). Meanwhile, the MSCI Europe gained 27% in the first year and 6% in the second year (in local currency terms).


Within the equity market globally, there were also powerful cyclical rotations. Cyclical sectors returned 34% on average in the first year, outperforming the more defensive ones by 5%. However, both groups performed in line with each other in the following year.

The best performing sectors in the 12 months following the trough were technology (+44% on average), basic resources (+43%), financial services, autos and media (all up +39%), while the main laggards were typically defensives such as utilities (+18%), telecoms (+26%), food retail (+26%) and healthcare (+27%). 

Direction of policy rates matters

The direction of policy rates has typically had a significant impact on the strength of equity rallies following ISM troughs. In analysing the rallies, cycles are split into four stages, depending on whether the ISM manufacturing index was above or below 50, and whether it was rising or falling. Two scenarios were also considered: one when US 2-year Treasury yields were increasing, and the other when they were declining. 

Unsurprisingly, we found that market rebounds from ISM troughs tended to be weaker when associated with rising yields, based on data since 1980. Monthly returns in recovery phases (ISM manufacturing index below 50 and rising) averaged 2.0% when yields were declining, but only 0.9% when then were rising. 

A similar, but less pronounced, tendency occurred in mid-cycle phases, when the ISM manufacturing index was above 50 and rising. Monthly returns in those phases averaged 1.5% when yields were declining, and 1.3% when they were rising. 

How does the recent equity rally and sector rotation compare with previous ones?

When compared against previous rebounds around ISM troughs, the recent rally is particularly sharp and violent, especially given that a trough in the ISM manufacturing index has not been reached yet (see earlier chart).

This can be explained in the context of the severe drawdowns of last year. Global equities declined by 27% from their peak in January 2022 to their low in October 2022. Since then they have rallied by 14%, erasing close to half of their losses. 

Cyclicals have outperformed defensives by around 5% since mid-October, with some of the worst performers in the January to October period leading the rally. 

The best performing sectors since October have been industrials, financials, basic materials and technology, all up 17% to 19%. The main laggards have been energy (+1%), followed by consumer staples, healthcare and utilities (all up 7% to 9%). Energy was the only sector in positive territory and up strongly in the January to October period, while staples, utilities and healthcare were the sectors that saw the smallest drawdowns.

The relative performance of cyclical sectors against the more defensive ones appears to have overshot the improvement in the growth outlook

Following the rally, global equity prices seem broadly consistent with the current level of activity, as proxied by the ISM manufacturing index. However, the relative performance of cyclicals versus defensives appears to be discounting the start of an economic recovery, which is not yet visible in the survey data (see chart).


However, this apparent disconnect is justified given the outlook for monetary policy

Drilling down to the sector level reveals that sectors which have overshot (undershot) their historical relationship to the ISM Manufacturing index, also tend to outperform (underperform) when interest rates are rising. Their relative performance is positively (negatively) correlated with changes in US 10-year yields (see chart).


The vertical axis in the chart shows how the sectors have performed in the past year, relative to the performance one would expect given their historical relationship with the ISM Manufacturing index over the past 20 years, expressed in z-scores. Positive (negative) z-scores indicate the degree to which they have overshot (undershot) the value implied by the index. The horizontal axis shows the correlation between the sector’s relative performance and changes in US 10-year yields.

It is apparent that the sectors that have lagged their historical relationship with the ISM index are also some of the most expensive, long-duration parts of the market: retailers, technology, media, telecoms, consumer staples and healthcare. Their expensive valuations and long-duration cash flows make them particularly vulnerable in a rising rates environment, similar to the one we have experienced in the past couple of years.

As long as leading central banks maintain their hawkish stance and the market worries about rates being higher for longer, those sectors are unlikely to catch up with cyclicals and value stocks.

In contrast, financials and commodity sectors, such as energy and basic materials, have overshot their relationship with the ISM index of late. They are both cyclical and value sectors, and tend to outperform in periods of rising interest rates and improving economic momentum. They are generally more sensitive to yields and commodity prices than to the business cycle, and we would expect this to remain the case in the coming months.

This is why we maintain a positive stance on the energy and banking sectors, despite those sectors looking extended vs the ISM.

What this means for investors

The recent rally in equities is unlikely to be sustained until we see clear signs that activity has troughed and that interest rates have peaked. Historically, rate cuts (not simply a pause in rate hiking cycles) have been needed for equity markets to rebound in a sustainable way. Until then, consolidation is more likely at the index level. 

If the ISM manufacturing index does indeed trough in the near term, and the economic momentum improves, we believe the next leg of the rally is unlikely to be as strong as in previous episodes for a number of reasons:

  • Global equity valuations are now back in line with their 10-year averages, after the recent rebound
  • Sentiment is no longer depressed
  • Unless we see a dovish pivot from central banks, rates are likely to be higher for longer than expected, thereby keeping a lid on valuations in the coming months

In the meantime, the sectors that have lagged in the recent rally are unlikely to catch up, as they tend  to be most vulnerable to high interest rates and restrictive monetary policies.

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