‘Rare’ rally in cyclical stocks largely over, Goldman warns, after ETF investors favored such areas of the market

U.S. cyclicals have outpaced defensives by a large margin since the start of May, rising 18%, and “investors want to know if the rally can continue,” the Goldman analysts said. Their note shows that defensive stocks rose just 2% over the same three-month period. They pointed to “wide dispersion” at the sector level. 

Automobiles and components were the best-performing cyclical group excluding commodities during the three months through July, with a gain of 53%, while stocks in the area of consumer durables and apparel fell 1% for the worst performance in the category, according to the note. 

“Ultimately, the forward path of economic growth will determine whether cyclicals have more room to run,” the analysts said. Their research found that “when growth decelerated after sharp cyclical rallies, defensives began to outperform,” with the analysts cautioning that Goldman’s economists forecast that growth will decelerate to 1.6% in the third quarter on an annualized basis before slowing to 1.1% in the fourth quarter.

“The recent cyclical rally seems to price an overly optimistic growth outlook of more than 2%,” they wrote. “The Fed’s battle with inflation puts a ceiling on economic growth.”

Recent signs of cooling inflation in the U.S. and low unemployment have led Goldman’s economists to lower “their subjective probability” of a recession during the next 12 months to 20%, according to the note. But “after sharp cyclical rallies, meaningful improvement in economic data is required for cyclicals to continue outperforming in the median experience,” the analysts said. 

ETF flows

Meanwhile, investors in equity ETFs favored cyclicals in July, as sector flows underscored their appetite for risk-taking in markets, according to Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors.

Equity ETFs attracted around $120 billion over the past three months, “the highest three-month total in 2023 and a significant rebound from earlier in the year,” he said in a research note tracking July flows into U.S.-listed exchange-traded funds.

Sector ETFs last month saw $7.5 billion of inflows, the most since October, with cyclical areas being the most popular, according to Bartolini. 

“The strong flows were led by cyclicals, as those market exposures took in almost $8 billion while defensives had outflows,” he said. “Cyclicals have now outpaced defensives for two consecutive months.” 

Bartolini said “this is the first time that has occurred since the start of 2022,” illustrating how investors have been “more willing to express risk recently.”

The financial sector mainly drove cyclical flows, “as better-than-expected bank earnings repaired sentiment toward the industry after the mini-crisis earlier in the year,” according to the State Street report. But “every cyclical sector had inflows in July,” Bartolini wrote.

U.S. stocks were trading lower Wednesday afternoon, with the Dow Jones Industrial Average
DJIA
down 0.9% while the S&P 500
SPX
fell 1.3% and the Nasdaq Composite
COMP
sank 2%, according to FactSet data, at last check. 

Investors were digesting data Wednesday from payroll processor ADP that showed U.S. private-sector employment jumped in July more than anticipated. They were also assessing the decision by Fitch Ratings to downgrade the U.S.’s credit rating to AA+, from AAA, because of the government’s debt burden and an “erosion of governance” seen in repeated debt-limit standoffs.

The S&P 500’s defensive sectors were outperforming the broad U.S. equity market in Wednesday’s slump, with consumer staples
XX:SP500.30
and utilities
XX:SP500.55
showing small gains, FactSet data show, at last check. The rest of the index’s total 11 sectors were trading down Wednesday afternoon.