Cyclical sector rally banks on global economic expansion

U.S. energy, industrial and financial stocks in the spotlight

October 14, 2017 09:03 pm | Updated 09:05 pm IST - NEW YORK

Close scrutiny: Investors will parse earnings from 40% of PHLX semiconductor index’s components. Reuters

Close scrutiny: Investors will parse earnings from 40% of PHLX semiconductor index’s components. Reuters

U.S. stock sectors that are particularly dependent on economic growth recently grabbed hold of the markets rally and are poised to keep the reins should further signs of global expansion emerge.

Such sectors, including energy, industrials and financials, beat the S&P 500’s 1.9% gain in September. Those sectors had previously lagged behind the benchmark S&P, which has climbed 14% this year while feasting on a steady diet of record highs. Instead, shares of technology and healthcare companies, whose profits are more impervious to economic down cycles, have led 2017’s rally.

The question for equity investors is now: Was September just a catch-up period for the lagging, cyclical sectors, or can an economic lift support a sustained run?

An inflection point

“If it’s just a mean-reversion trade, then it’s probably going to last another few weeks and then we’re back to the old winners,” said Walter Todd, chief investment officer at Greenwood Capital Associates. “If it’s something more fundamental, it should be longer lasting than that.”

A test comes next week, as third-quarter corporate earnings season kicks into high gear. Reports from industrial conglomerates General Electric and Honeywell International, railroads CSX Corp. and Kansas City Southern and steel company Nucor Corp. stand to yield insight into the economy’s health.

September’s stock action, which also included outsized gains for small-cap stocks, had echoes of the immediate aftermath of President Donald Trump’s election in November 2016.

Policy hopes

The same areas showed strength on hopes that a Republican-led federal government would push through an agenda, including tax cuts and deregulation, that juices economic growth. Those trades faded as Mr. Trump struggled to rack up any significant legislative wins.

Now, investors say, September’s stock rally for those groups again stemmed at least in part from policy hopes, as Mr. Trump revved up his tax-reform push.

“In many ways, we began to replicate the market performance following Trump’s election,” said Quincy Krosby, chief market strategist at Prudential Financial.

But an improving economic picture in the U.S. and globally lends confidence for the cyclical sector rally. The Citi economic surprise index for the U.S., a measure of economic data that can come in weaker or stronger than forecast, is around a five-month high, with the barometer trending higher since hitting multi-year lows this summer.

The International Monetary Fund has upgraded its global economic growth forecast for 2017 by 0.1 percentage point to 3.6%, and to 3.7% for 2018, from its April and July outlook, driven by a pick-up in trade, investment, and consumer confidence. The U.S. Commerce Department last month revised its estimate for second-quarter gross domestic product growth to 3.1%, up from 3%.

Sea freight data

“We’ve just had better data,” said Jim Paulsen, chief investment strategist at The Leuthold Group, who also points to indicators such as firming industrial commodity and oil prices and a rise in the Baltic Exchange’s main sea freight index.

“Those things are all kind of reflecting a realism of economic momentum, not just a one-off, Trump pie-in-the-sky expectation about policy change,” Mr. Paulsen said.

Bets seemed to build on the cyclical sectors in the first week, which saw flows into the largest sector exchange-traded funds for financials, industrials and energy, and outflows for technology and healthcare, according to Lipper data.

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