Stubbornly strong services data is finally slowing. The NY Fed Weekly Economic Index slipped lower over the past few weeks “due to falls in retail sales, consumer confidence, and railroad traffic, and a rise in initial unemployment insurance claims…” (release HERE). OpenTable Dining and TSA Travel data have moved lower as well. Those trends are a growing risk for Deep Cyclicals, which usually underperform as growth slows.
Based on the latest Strategy survey (result HERE), 93% of the investors surveyed put the odds of a recession next year above 50%. 30% of respondents put recession odds above 90%. Deep Cyclical relative performance has diverged significantly from economic measures, leading to the largest spread between the two in at least a decade.
Over the past three earnings seasons, earnings were revised lower, dragged down by both Defensives and Deep Cyclicals. 3Q earnings estimate revisions have been much weaker than in 2Q as growth slowed. Margin deterioration has been a particular issue for Materials. Though margins and sales have deteriorated for all Deep Cyclicals sectors, margin contraction within Materials in 4Q was the deepest.
To select within Deep Cyclicals, at the end of this report, we list the S&P 1500 Deep Cyclical names that fall into the top quintile of Quality of Earnings and Realized Growth. Both those factors should benefit from slowing growth, and the decline in correlations we expect to see as macro influence eases next year.
Deep Cyclicals Face Growing Macro Risks: Economic growth has slowed, with leading indicators such as the Manufacturing PMI and Conference Board Consumer Confidence collapsing. Stubbornly strong services data looks to be slowing now too. The NY Fed Weekly Economic Index slipped lower over the past few weeks “due to falls in retail sales, consumer confidence, and railroad traffic, and a rise in initial unemployment insurance claims…” (release HERE). OpenTable Dining and TSA Travel data have moved lower as well. Those trends are a growing risk for Deep Cyclicals, which usually underperform as growth slows. Deep Cyclical relative performance has diverged significantly from economic measures, leading to the largest spread between the two in at least a decade.
Based on the latest Strategy survey (result HERE), 93% of the investors surveyed put the odds of a recession next year above 50%. 30% of respondents put recession odds above 90%. If there is a recession next year, PMI reading should drop further, putting more downward pressure on Deep Cyclicals, especially Materials and Industrials.
Historically, Energy stocks returns are most impacted by oil prices and the two series are highly correlated. The spread between Energy relative returns and oil widened out significantly from July to mid-November. Recently, that spread has started to narrow with S&P Energy falling to catch up with still declining oil prices.
The oil cycle has caused shifts in the factor exposure of Energy, which has diverged from Materials and Industrials. Energy today is MUCH more exposed to Momentum of Price, Realized Growth and Earnings Turbulence, while Materials and Industrials remain to be more exposed to Low Volatility and Realized Profitability. In addition, the improvement of supply chains helped the outperformance of Industrials recently, as discussed in a Strategy report today (HERE). That tailwind is fading now that supply chain pressures have eased (HERE).
Fundamentals Headwinds Also Growing: Over the past three earnings seasons, earnings were revised lower dragged by both Defensives and Deep Cyclicals, which were led lower by Materials. 3Q earnings estimate revisions have been much weaker than in 2Q as growth slowed, and should remain a drag for Deep Cyclicals into 4Q reporting.
Fundamental sentiment within Deep Cyclicals have also diverged. Energy has been a leading sector on both forward-looking earnings and current financial sentiment. While Materials earnings and financial sentiments are both lower than the index, consistent with its weak revisions. Industrials sentiment is right in line with the overall index.
Margin deterioration has been a particular issue for Materials. Though margins and sales have deteriorated for all Deep Cyclicals sectors, margin contraction within Materials in 4Q was the deepest. Materials rally in 4Q is more driven by multiple expansion.
As growth is expected to slower further, we favor the names with high earnings quality and growth. Below are the S&P 1500 Deep Cyclical names with top quintile Quality of Earnings and Realized Growth score, which the factor exposure should help offset the drag from slower economic growth.
