Since late last year, the U.S. stock market has started to favor defensively orientated sectors.
Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models. Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal.
These nascent trend changes have developed even though the economic data have generally surprised on the upside. This may be an indication that a more forceful response will occur once the string of upside surprises loses momentum. For instance, the global PMI has been very strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive versus cyclical stocks. Keep in mind that the market is priced for a non-inflationary growth nirvana and even modest economic disappointments could short circuit the buying binge.
Moreover, the 2/10-year Treasury yield curve has stopped steepening and financial conditions are no longer easing. This provides additional confirmation that the defensive versus cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend.
Bottom Line: Evidence of a sub-surface trend change continues to materialize, even in the face of upward momentum in the broad market. Our U.S. equity strategists expect a mostly defensive portfolio structure, along with select interest rate-sensitive exposure, to outperform in the next 3-6 months.