Sector tilting or rotation is an investment strategy that involves shifting investment allocation to sectors that would likely benefit from the anticipated (next) stage of the economic or business cycle. The strategy is based on the assumption that economies move in a reasonably predictable cycle. And each stage of an economic cycle influences different sectors differently.
Equity indices attempt to harbinger the state of the economy months in advance. Investors move their money into sectors that are expected to outperform during the coming stage. As the prediction (of the coming stage of the economic cycle) changes with the passage of time, they shift their focus from a sector that has reached its peak to a sector showing the potential to rise. This is how they can capitalize on a change in economic conditions and earn higher returns. This is not a passive strategy and requires periodic rebalancing of sector holdings.
What drives the economic cycle?
Data from the National Bureau of Economic Research (NBER) demonstrates that economic cycles have been fairly consistent since at least 1854. The primary drivers that cause an economic cycle to move are changes in foreign exchange and interest rates.
As an economy expands, strong demand for raw materials creates inflationary pressures, which causes the interest rates to rise. Higher interest rates increase the value of a currency and reduce the competitiveness of exports, which leads to a decline in manufacturing-led exports. This, along with the rising cost of capital bring about an economic contraction.
Economic contraction subsequently reduces the demand for raw materials, which creates deflationary pressures and causes interest rates to decline. Lower interest rates decrease the value of currency and increase the competitiveness of exports, which lead the demand for production to rise. This, along with a lower cost of capital, cause the economy to expand, starting a new economic cycle and so on. During the process, the relative performance of sectors shift, in general, in a predictable manner.
How sector rotation works?
The graph below shows the economic cycle in blue, the market cycle in red, and the outperforming sectors at the top. Stages of the economic and market cycle are also marked. The centerline reflects the contraction/expansion threshold for the economy.
In general, the stock market does not move with the economic cycle, but in anticipation of the economic cycle. That is why market cycle is approximately three to six months ahead of the economic cycle.
The stages of an economic cycle:
- Full recession: Full recession reflects a bottom in the economy, with falling interest rates and record-low economic output. However, stocks anticipate the economic recovery ahead, with technology and consumer cyclical driving the beginning of a bull run.
- Early recovery: Early recovery shows economic output starting to pick up and interest rates bottoming out. Lower cost of funds and improving outlook drives growth in industrial production. Due to rising demand in recovering economy, commodities turn up in anticipation of strong economic expansions. This leads to basic materials and energy stocks driving the market top.
- Full recovery: Full recovery reflects a peak in economic output. To combat the higher inflationary pressures, interest rates start to increase. This would pressurize further economic expansion. Stocks anticipate a recession ahead by peaking before the expansion period ends. When the higher commodities price starts hurting the economy, energy stocks lose their attraction to consumer staples.
- Early recession: The early recession phase sees skyrocketed interest rates impacting industrial production, which leads to economic deterioration.
In anticipation of a full recession, the market remains bearish. Central banks start to lower interest rates to provide economic stimulus. The subsequent reduction in the cost of capital may benefit debt-laden utilities and encourage bank landings. This will lead to a market bottom and the cycle repeats.
Here the important thing to note is the sector/stock performance is always relative to the overall market. During a bear market, it is expected that the price of all stocks will decline.
Examples of sector rotation
Sector rotation in the 2000s:
We analyze two different time periods in the movement of the S&P 500 to understand the relative performance of the economic sectors (9 S&P sector SPDR ETFs at that time). The first is the 2003 market bottom and the other is the 2007 market top.
The S&P 500 bottomed in March 2003 before going through a bull run that lasted until October 2007 market top. As expected, consumer discretionary and technology sectors known to begin a bull run while anticipating the recovery ahead led the market performance.
Sectors’ performance in 2003 market bottom
Sectors’ performance in 2007 market top
The S&P 500 peaked from July to October 2007 before declining in Q4 2007. As expected at the market top, the energy and materials sectors outperformed the others while consumer discretionary lagged.
Sector rotation in the 2020s:
Stock market performance in the last three years has been heavily influenced by the COVID-19 pandemic, which caused the global recession, the unprecedented government stimulus as well as inflationary pressures, and supply-chain issues. We look at two time periods in the S&P 500, viz. the 2020 market bottom and 2022 market top.
The S&P 500 bottomed in March 2020 when the virus started spreading out of China resulting in stringent lockdowns, before going through a recovery driven by the relaxation of social restrictions. As usual, technology and consumer discretionary stocks started the bull run before the leadership was shifted to materials and industrial stocks.
Sectors’ performance in 2020 market bottom
Sectors’ performance in 2021-22 market top
Similarly, when the S&P 500 peaked from November 2021 to January 2022, energy sector outperformed the others as expected, while consumer staples was emerging and technology lagged.
Which sectors are expected to perform well in the near-term future?
While the US economy has gone through a strong post-covid recovery, high inflation and resurgence of COVID-19 cases put an enormous strain on further expansion.
As per advance estimates released by the Bureau of Economic Analysis (BEA), Q1 2022 GDP unexpectedly declined 1.4%, while missing even the subdued Dow Jones estimate of a 1% growth.
S&P 500 is already trading 19% below its January 2020 peak, while the 40-year high inflation forced the federal reserve to plan a series of rate hikes.
These economic conditions closely resemble the end of an expansion phase in an economic cycle. Many investment banks forecasted a mild recession ahead with a low probability, including Goldman Sachs and Morgan Stanley.
With this economic backdrop in mind, defensive sectors like consumer staples, utilities, and healthcare are expected to relatively perform well in the near future; while technology, industrials, and consumer discretionary may continue to fall behind for some time.