U.S. Equities: Timing A Turn In Cyclicals Vs. Defensives

Despite some disappointment in recent economic data, the main macro drivers are consistent with a recovery in cyclical vs. defensive stocks.

US Equities, Cyclicals versus Defensives

G lobal purchasing manager surveys in both the manufacturing and services sectors continue to herald a cyclical recovery. Asian manufacturing inventories are contracting, and new orders are rising, pointing to an upturn in output growth, a boon for goods-producing economic-sensitive businesses.

Meanwhile, hours worked in the U.S. transportation sector are soaring, reinforcing that global trade is on the mend.

Importantly, global policy is ultra reflationary, and our global leading economic indicator is rising. This stands in contrast with the summer equity market swoons over the past few years, which were marked by worries of a euro area blow up, U.S. debt ceiling debacle and Chinese policy tightening.

These factors imply that macro forces are consistent with cyclical sector earnings outperformance in the coming quarters. Profit outperformance may not even be a necessary condition for a rebound in the relative share price ratio. The ratio is already priced for a global recession. The slow improvement in global economic sentiment points to a re-rating in the coming quarters.

In sum, profit, valuation and macro considerations argue for a rebound in the cyclical to defensive share price ratio, which would imply that a leadership transition will occur. Potential catalysts for such a development would be an end to the appreciation in the U.S. dollar and/or a backup in global bond yields on the back of increased global economic activity. As a result, our U.S. Equity Strategy service is sticking with a largely cyclical vs. defensive portfolio bias.

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President Obama Places His Cards On The Table

President Obama’s FY 2014 budget threw investors a curve ball, as he openly and explicitly offered concessions on entitlements to the Republican leadership.

President Obama Curve Ball

T he president’s negotiating strategy is to be transparent about his willingness to make concessions in order to secure a “balanced” agreement. However, US$580 billion in new revenue from closing loopholes and reducing benefits for the wealthy was also included in the budget, something that is sure to ruffle some GOP feathers. Fiscal stimulus measures proposed for 2014-15 will also add to the deficit in the near term. The deficit projection under the President’s budget lands between the Democratic and Republican estimates (albeit much closer to the Democratic position).

Essentially, the President has put the GOP leadership in a position where they must argue against increasing revenue through higher taxes for the wealthy. We witnessed how difficult that position can be during the fiscal cliff negotiations when the Republicans got nothing in return for higher tax rates on the rich. In short, revenue is the critical hurdle to an agreement that gets political leaders to the targeted US$4 trillion in deficit reduction over 10 years.

There is a chance that the GOP will not be able to make the concessions on revenues necessary to secure a broad deal, and thus decides to simply fund the government with another continuing resolution (CR) at current spending levels imposed by the sequestration. The CR would be passed either before the next shutdown deadline (September 27) or shortly thereafter. This result would be market-neutral, since it is the outcome that is already discounted, although it would mean that the onerous fiscal drag currently in place for FY2013 would go unaltered.

That said, a broader budget deal is not out of the question. Indeed, a deal is more likely than is currently anticipated by investors, which means it would be positive for risk assets.