USNov 25 2020

What does 2021 hold for US cyclicals?

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DO NOT USE T Rowe Price
What does 2021 hold for US cyclicals?
Pexels/Artem Beliaikin

The people may have spoken but the American political system still remains divided, with the Democrats failing to take control of the Senate as it stands.

Add into the mix a pivotal runoff election in January and an incumbent who still refuses to concede at the time of writing, and cyclicals face further potential headwinds.

“Given the prospect of divided government in the US for at least two more years, we’ll probably only see a very diluted version of [president-elect Biden’s] economic plan,” says Bo Brownlee, partner and portfolio manager at Secor Asset Management. 

“The likely result being less fiscal stimulus than he had envisioned, fewer and smaller tax hikes and continued monetary easing.”

If Republicans still control the Senate by January, then president Biden’s period will be difficult, and his ability to get things done will be minimal Peter Garnry, Saxo Bank

This all means investors are once again having to do further analysis on the US political system given a lack of an emphatic outcome. The Democrats could yet win control of the Senate if they triumph in two Georgia runoff elections being contested on January 5 – which means there is now another date in the calendar to watch.

Should the Democrats prevail, there would be a greater chance of more fiscal stimulus and bigger investments in green energy. This, explains Saxo Bank head of equity strategy Peter Garnry, would result in inflation and lead to higher rates.

“If Republicans still control the Senate by January, then president Biden’s period will be difficult, and his ability to get things done will be minimal unless Republicans post the Trump era decide to bend their views towards the Democrats,” adds Mr Garnry, who does not see the latter scenario as particularly likely.

“A constrained Biden administration is perceived by the market as positive because it will postpone technology regulation, avoidance of higher corporate taxes, and no healthcare reform on drug prices. This scenario is net positive for the healthcare, IT and communication services sectors which dominate the US equity market.”

A fresh start

In the most basic terms, cyclical stocks need good economic news and this year hasn’t featured a lot. Fortunately, recent breakthroughs on the vaccine-development front have given both society and markets a much-needed boost. 

Catherine Doyle, investment strategist for the BNY Mellon Global Real Return fund, is optimistic in her outlook: “2020 was the year of the coronavirus and lockdown, while 2021 promises to be the year of reopening and recovery. 

“Stay at home plays in areas such as technology have worked well this year but those companies more sensitive to the resumption of economic activity, such as homebuilders and automotive stocks, should shine as we move into 2021.

"In fact, stocks have already bounced off the back of these initial yet promising updates. Sectors such as travel, retail and financials have all rallied and investors have been forced to reconsider how defensively they need to be as we move into 2021. 

“It would be reasonable to expect that the earnings of cyclical stocks would recover, particularly as economic activity returns to more normal [pre-Covid-19] levels and experience improved performance,” says Julian Cook, US equity portfolio specialist at T. Rowe Price. 

“[However] it may be too much to expect that this would be the start of a new economic cycle rather than a return to the low growth, low inflation and low interest rate environment that existed prior to the exogenous shock of the pandemic that would favour the secular growth companies.”

Energy are usually a cyclical sector that would benefit from a shift in sentiment. However, such shares instead face a much more different 2021, according to Mr Garnry.

“The sector still has a big overhang on the supply side and therefore it is not a given, even with a Covid-19 vaccine, that this sector will do great,” explains Mr Garnry, who also points out energy will come under more scrutiny with a president who put climate change at the forefront of his campaign.

“Oil and gas companies are also facing tough headwinds from regulation, and the political capital invested to push forward the green transformation which is a negative on the demand side. Higher interest rates will have the biggest impact on growth stocks with the largest share of the present value of cash flows coming far into the future, so there is a whole speculative growth segment in the equity market that could be in for a choppy 2021.”

An outdated term?

Given the drivers that might power markets going into 2021, the conversation around cyclicals is an inevitable one. However, the unprecedented dynamics of 2020 may have irreparably altered how investors need to think about the role they play in portfolios.

“The cyclical versus defensive split of stocks is useful but also over-simplified,” says Andrew Pease, global head of investment strategy at Russell Investments. 

Here he uses the example of tech stocks that are usually regarded as cyclical, but will likely end up losing out in a post-pandemic recovery as a temporary boost in profits subsides and rising discount rates reduces the value of future earnings.  

Instead, Mr Pease argues factor exposure is a better way of assessing equities. In his outlook, value will likely benefit: “One sector worth watching is the financial sector. In particular, banks should benefit from steeper yield curves, over-generous loan-loss provisions that can be released back to earnings, and lending growth that could exceed pessimistic expectations. Banks globally trade at a large valuation discount to the broader market.”

Jon Yarker is a freelance journalist