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As the Economy Starts to Normalize, the Market Looks to Cyclicals

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What You Need to Know

  • As vaccine distribution and the effects of the stimulus progress, we should root for slightly higher inflation and higher rates.
  • These conditions point to increased opportunity this year in economically sensitive cyclical stocks.
  • Consider manufacturing, mining and chemicals, as well as consumer, auto, and companies that benefit from increased home buying.

We are entering the second quarter of 2021 on a relatively positive note: The latest round of stimulus is underway, vaccination progress is continuing, more businesses are reopening, and we are starting to see improvement in the employment situation. Additionally, the U.S. 10-year note yield has risen 87% since early January, a sign that the market believes the economy is recovering.

Notable investment themes right now are increased consumer spending, strength in the manufacturing sector and a focus on industries that will benefit from President Joe Biden’s proposed infrastructure package. As such, my equity portfolio remains 70% cyclicals, focusing on economically sensitive stocks with exposure to the economic recovery.

Interest Rates: Signs of a Normalizing Economy

Since starting January at below 1%, the U.S. 10-year Treasury yield is now at 1.727%. While this rise in rates may have shaken the market in Q1, it’s a sign that we are emerging from the crisis and the economic outlook is improving. When you consider that the economy shut down completely in March 2020 and take into account where we are today, the rise in interest rates is to be expected.

As vaccine distribution progresses and the fiscal stimulus continues to filter into the system, I believe we should actually be rooting for a little more inflation and higher rates. Markets can handle 2-2.5%, as long as rates are going up for the right reasons — namely, stimulus jolting the system.

I believe the U.S. 10-year note will hover from a 1.6% low to 1.75% on the high end — not dissimilar to where we were in early 2020, pre-pandemic.

The Infrastructure Boost

Biden’s proposed $2 trillion infrastructure package is aimed at creating jobs and providing further stimulus to the economy. While it will add to corporate tax rates, it will boost manufacturing industries, which constitute 12% of GDP. This doesn’t even include the sector’s multiplier effect on the broader economy: For every job created in industrial and manufacturing, 7.7 other jobs are created. An infrastructure package will clearly go a long way toward helping the nearly 10 million Americans who are still unemployed.

Biden proposes paying for the eight-year, $2 trillion infrastructure plan with 15 years of corporate taxes. While this is a concern, U.S. companies have done a remarkable job in terms of restructuring, reorganization and price increases and, in my view, can absorb higher taxes. 

Another impact of higher corporate taxes will be a lower dollar over time, which will bolster U.S. multinational companies.

Economic Indicators to Watch

Signs of accelerating economic activity are evident in purchasing managers’ surveys. The Chicago Purchasing Managers Index (PMI) came in at 66.3 in March, the highest it’s been since July 2018. The Chicago prices paid index rose for a seventh straight month, touching its highest level since August 2018. IHS Markit’s U.S. Services PMI rose to 60 in March, up from 58.8 in February. This level represents the strongest expansion in the service sector since July 2014. Notably, the rate of input price inflation was the sharpest since data collection began in late 2009.

The housing situation, meanwhile, has changed in the last month. U.S. mortgage applications fell for the fourth consecutive week, a sign not of slowing demand, but of reduced supply. At the same time, the median price of a new home in February was $349,000, up 5.3% from a year before — and the mean price of a new home is up 7.7% — an affordability issue that investors should keep an eye on, as it could potentially affect demand in related industries. 

That said, housing remains strong on an absolute basis, given that demographic trends point to more millennials buying homes. When considering investing in companies affected by housing — such as large hardware chains, paint companies and other home improvement plays — remember that housing represents 15-18% of GDP. Like manufacturing, homeownership also has a multiplier effect. After purchasing a home, consumers need to buy items to fill it, which boosts spending. 

Structuring Portfolios: Overweight Cyclicals

Higher growth, combined with modest inflation, suggests increased opportunity this year in economically sensitive cyclical stocks. My portfolio is currently 70:30, cyclicals to growth. Consider manufacturing  — including semiconductor manufacturing — mining and chemicals, as well as consumer, auto, and companies that benefit from the increase in home buying. I watch for companies with operating leverage, and strong top-line revenue growth and margins.

I continue to look closely at the consumer savings rate, which stands at 19.8% compared with the historical norm of 5%. This high savings rate represents an enormous amount of pent-up demand. As the economy opens up and consumers resume shopping, traveling, eating out and other entertainment, we can expect a significant amount of new spending, which will fuel growth in the stock prices of companies on the receiving end of renewed consumer optimism.

While I don’t believe in pitting value against growth, I see more opportunity in value in the coming months. Energy is the leader — with the S&P 500 Energy Sector Index up 29% since Jan. 1 — but the financial sector index is also up 17% and the materials index is up 10%. These are key areas to watch as the economy starts to accelerate.

With GDP expected to recover significantly in 2021 — in my estimation, perhaps reaching 8-10% growth — earnings stand to benefit. We could see S&P earnings growth for this year versus 2020 levels, possibly north of 30%. 

While my equity portfolio is about 70% cyclicals, including value stocks, I have 30% in growing technology companies — for example, 5G companies, cloud computing, artificial intelligence and wearables. I firmly believe that the total addressable markets in these areas are significant and cannot be overlooked in a diversified portfolio.

The first quarter of 2021 certainly looked different than Q4 2020. Yields have climbed back to pre-pandemic levels, the stimulus checks are getting cashed and spent, and leading indicators for increased economic activity — such as copper prices — continue their march upward. Combined with improving U.S. economic data, it’s clear to market participants that the stimulus and vaccines are working. 

We can expect to see hotter inflation numbers in the coming weeks and months, which may spook some market participants. However, those of us who remember the economy pre-2008 know that a “normal” healthy economy is characterized by a bit of inflation, better growth and higher interest rates. With that in mind, investors in cyclicals and value stocks should watch the recovery’s progress closely. Don’t follow the herd, and think carefully about when to trim allocations and rotate holdings.


Stephanie Link is chief investment strategist and portfolio manager at the national wealth management firm Hightower. She leads the firm’s Investment Solutions Group, which specializes in outsourced chief investment officer services, model portfolios, separately managed accounts, investment research and due diligence for Hightower advisors. Follow Stephanie on LinkedIn and Twitter @Stephanie_Link

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