Key takeaways:
- Technology companies have gone from massive underperformers to once again dominating equity markets.
- Year-to-date technology and the tech-heavy consumer discretionary sector are up 32% and 39% respectively.
Russ Koesterich CFA, JD, Managing Director, and Portfolio Manager discusses how improving economic expectations may suggest adding to cyclical areas of the market.
Like many trends that abruptly reversed in early 2023, technology companies have gone from massive underperformers to once again dominating equity markets. Year-to-date, technology and the tech-heavy consumer discretionary sector are up 32% and 39% respectively (as measured by the respective S&P GICS sector index). This year’s performance is handily beating the market as well as trouncing last year’s winners, energy, and low-beta, defensive stocks.
That said, while tech companies continue to grind higher on a surge of enthusiasm for all things related to artificial intelligence (AI), relative performance has shifted. Recently many cyclical parts of the market, including the industrials sector, have outpaced the broader market as well as tech. This shift in leadership has coincided with a steady stream of better-than-expected economic data. As economic expectations improve, the equity rally has expanded to favor more cyclical companies. I would expect this trend to continue and would consider adding exposure to industrial stocks.
Recession fears subsiding
In contrast to earlier in the year, recession fears are abating and growth expectations rising. A Bloomberg consensus of 2023 U.S. gross domestic product (GDP) forecasts growth at 1.3%, a significant improvement from January’s consensus of 0.5%. And although inflation estimates have started to slip, the consensus is still around 4%. Taken together, this suggests nominal GDP (NGDP) of 5% or more.
Nominal GDP matters as it is closely related to corporate earnings. If nominal GDP is likely to come in better than expected, earnings probably will as well. This shift would disproportionately benefit cyclical companies whose revenue is more closely linked to the economic cycle.
Not everything is expensive
Valuation is another factor favoring cyclicals. In aggregate, U.S. equities are trading at approximately 19x forward earnings, well above the historical average and a premium to most international markets. However, the premium is being driven by a relatively small number of stocks, mostly in technology and tech-related areas. Outside of these, most sectors, including industries, are trading at or below their long-term average (see Chart 1).
Apart from a stronger economy and cheaper valuations, many industrial companies, particularly in manufacturing and automation, stand to benefit from longer-term secular themes. Despite artificial intelligence has captured the public’s imagination, other innovations and trends may prove just as profound. A rapidly changing geopolitical landscape, pandemic-induced supply concerns, and a renewed focus on defense spending are driving generational shifts. For example, after decades of building increasingly complicated global supply chains, companies are now focusing on resilience rather than just cost. The net effect is a trend towards onshoring and ‘near-shoring’, i.e., locating manufacturing in adjacent and friendly countries.
What does this trend mean for broader portfolio positioning? While I still like tech and would maintain a long-term overweight, there are other opportunities that might justify a modest shift in positioning. A more resilient economy, reasonable valuations, and a compelling set of long-term tailwinds suggest that it may be an opportune time to take some profits in tech and redirect to select industrials.
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