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Drop in Cyclical Stocks Isn’t a Hard Fall for the Economy

Drop in Cyclical Stocks Isn’t a Hard Fall for the Economy

Wednesday, 11 July, 2018 - 07:45
Investors appear to be losing faith in an economy that does not yet appear to be losing steam.

For the first time since late 2015, cyclical stocks are all of a sudden the market’s biggest losers. The Vanda Cyclicals-Defensives US index, which as the name suggests measures the relative performance of cyclical stocks against defensive ones, is down 7 percent since peaking on June 6. In 2015, falling oil prices and worries about the Chinese economy prompted the decline in cyclicals. The unusual aspect of the latest drop is that the economy appears to be doing well by most accounts.

The latest evidence came from the jobs market. On Friday morning, the Bureau of Labor Statistics reported that employers added 213,000 jobs to their payrolls in June, which was 18,000 more than expected. The unemployment rate rose to 4 percent from 3.8 percent, in part because more people entered the workforce.

The biggest worry is that President Donald Trump could drag the U.S. into a trade war, which the market seems to think could essentially wipe out all the gains from the tax cut. Even so, few economists think a U.S. recession is possible this year or even in 2019. Of course, the stock market often reflects what investors think will happen, not what the economy is actually doing. Still, the recent drop in cyclicals may be less predictive than it appears.

The sector with the biggest drop in the past month was financials. The main culprit was most likely the nearly flat yield curve, which will curtail lending profits. A flattening yield curve can signal a slowing economy, but this time around the curve is narrowing in part because the Federal Reserve is raising short-term interest rates in light of what it perceives as a strong economy. International investors may be driving down long-term rates because the U.S. economy looks better than those elsewhere. Also holding back bank stocks in the past month were the results of the Fed’s annual stress tests, which were positive but seemed to unnerve investors anyway.

Consumer discretionary stocks, perhaps the best indicator of the U.S. economy, were actually up slightly in the past month. In fact, the story of the market of the past month seems to be less about a drop in cyclical stocks and more about a rapid rebound in defensive ones. Utilities were the big winner, up nearly 10 percent in the past month, once again most likely because of the yield curve — longer-term interest rates have not be rising as much as expected. Many investors reach for utilities when rates are low. Consumer staple stocks were up more than 6 percent, but those companies had been hit by investor fears that seemed unrelated to the economy, and those appear to have eased a bit lately.

The economy will sour eventually. But the recent dip in cyclical stocks could just be the market’s version of a trust fall, not a signal that the economy will soon be on its back.


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