The MSCI World cyclical sectors index last week briefly reached a new record relative to the companion defensive sectors index, seemingly ignoring a soft global economy and the negative impact of the coronavirus shock. Recent strength, however, has been driven by the IT and communications services sectors – “old economy” cyclical sectors have languished but could outperform over the remainder of 2020 if the “deep V” global economic scenario favoured here plays out.
The coronavirus shock, as previously discussed, has disrupted the normal leading relationship between money trends and economic activity – it has brought forward and magnified economic weakness suggested by a slowdown in global real narrow money since Q3 2019. It has also triggered policy and market responses that will probably result in a monetary rebound. In a benign scenario in which the virus is contained, the combination of catch-up activity and additional monetary stimulus could result in strong economic growth from mid 2020.
Are equity markets already discounting such a scenario? MSCI classifies the 11 GICS sectors as either “cyclical” or “defensive” depending on the strength of their correlation with the OECD’s composite leading indicator index for the OECD area as a whole. The ratio of the World cyclical sectors index to the defensive sectors index, while falling in recent days, remains close to a high reached in February 2018 despite sluggish economic momentum even before virus shock – see first chart. The global manufacturing PMI new orders index, for example, had retraced only 27% of its December 2017-August 2019 decline.
The cyclical sectors are: materials, industrials, consumer discretionary, financials, real estate, communications services and IT. Recent index strength has been driven by the latter two sectors. The second chart shows that the ratio of an index of the “old economy” cyclical sectors to the defensive sectors index is little changed from a year ago and down 9.5% from its 2018 peak, i.e. its behaviour has been more consistent with economic developments, as reflected by PMI new orders, than that of the aggregate cyclical / defensive sectors ratio.
The third chart shows additionally the performance of the tech sectors (IT and communication services) relative to the defensive sectors (consumer staples, health care, utilities and energy). It was necessary to double the chart scale to accommodate tech outperformance. In addition to the strong uptrend since 2015, tech suffered much less damage than the “old economy” cyclical sectors when global activity weakened in 2011, 2016 and 2018.
These observations question MSCI’s classification of the tech sectors as cyclical. The suspicion here is that the historical correlation with the OECD’s composite leading indicator – the basis of the classification – exaggerates the strength of the relationship, reflecting the coincidence of the early 2000s tech bust with the 2001 recession.
Tech sector outperformance has been driven partly by a rerating of valuations; price to book ratios of “old economy” cyclical sectors and defensive sectors are little changed from 2015 – fourth chart.
The suggestion from the above is that investors expecting a “deep V” economic scenario should consider adding exposure to “old economy” cyclical sectors at the expense of not only defensive sectors but also the tech sectors. Tech may be more exposed to near-term economic / market weakness but may deliver less cyclicality than the “old economy” sectors in a subsequent strong rebound.