Great Chart: US ST Yield Curve vs. Cyclical-Defensive Stocks

Lately, the sharp revision of the US annual saving rate (up 1.6% on average since 2010) shifted growth expectations to the upside and lowered the bottom of the unemployment rate for the next few quarters. For instance, Goldman revised its GDP growth to 3% in Q4 (from 2.5% previously) and to 2% for 2019 (vs. 1.75%) and expects the unemployment rate to bottom at 3% in 2020. As a result, some investors are starting to consider that we may see more rate hikes by the Fed than currently expected. With two more hikes priced in for this year and another two to three for 2019, market participants expect the Fed Funds rate to hit [at most] 3.25% by the end of next year, which is more or less in line with the  Fed’s dot plot released at the June meeting (median projection at 3.125% for 2019).

However, we saw that the market is not expecting any more hikes post-2019, which could be interpreted as the end of the tightening cycle by US policymakers. According to the Eurodollar futures market, the December 2019 and December 2020 implied rates are trading equally at 3.06%, which suggests that the US economic outlook is expected to slow down at the end of next year. Hence, an interesting analysis is look at which sectors should perform well within the next 12 to 24 months if we stick with the scenario that economic uncertainty will increase at the end of 2019. A classic strategy looks at the Cyclical vs. the Defensive stocks. The main difference between Cyclical and Defensive stocks is their correlation to the economic cycle; Cyclical stocks tend to do well in periods of economic expansion (relative to Defensive stocks) but tend to experience more losses during recessions. According to empirical research, one of the main aspects that drive Cyclical and Defensive stocks’ performance is the beta of these stocks (also called the market risk premium). As the Defensive stocks are more resilient to an economic downturn, their beta is lower than 1 (resp. higher than 1 for Cyclical stocks).

Therefore, if we take the EuroDollar (ED) Dec19-Dec20 implied rate yield curve as our leading indicator of the business cycle, a flattening yield curve should benefit to the Defensive stocks (vs. Cyclical stocks). However, the chart below tells us a different story (Original Source: Nomura). We looked at the relationship between Cyclical-versus-Defensive sectors and the Dec19-Dec20 ED yield curve since the summer of 2008, and noticed that the two times series have been diverging for the past two years. The yield curve has constantly been flattening during that period, however Cyclical stocks have outperformed Defensive Stocks. We chose Materials, IT and Industrials sectors for the Cyclicals and HealthCare, Telecom and Utilities sectors for the Defensives (Source: Thomson Reuters Total Return Indices), and compute the ratio of the Cyclicals and Defensives new indices (find attached the file).

If you expect the two series to convergence back together, this would imply either a sudden steepening of the yield curve or Cyclicals to underperform Defensives.

Chart: ED Dec19-Dec20 yield curve vs. Cyclical-Defensive stocks (Source: Eikon Retuers)

Sectors vs. YC.PNG

EXCEL DATA LINK ====> Sectors