In The Great Rotation, we explained why investors are likely to shift capital from consumer staples and other defensive sectors to cyclical groups such as energy, financials, industrials and technology toward the back half of the year.
Slow economic growth and the threat of extreme “tail risks” such as a European financial crisis and the US fiscal cliff have prompted investors to pile into defensive stocks, pushing valuations to frothy levels.
But as we highlighted in Heightened Risk, Emerging Opportunities, US economic growth should recover in the back half of the year. The better-than-expected June employment figures released by the US Bureau of Labor Statistics are further evidence that the economy has proved remarkably resilient to tax hikes and spending cuts enacted in the first half of 2013. As these headwinds fade, look for the economy to reaccelerate into 2014.
Industrials stand to benefit from a strengthening economy; the sector has traditionally turned in a strong performance when US gross domestic product expands at an accelerated rate. For example, the S&P 500 Industrials Index generated a total return of 82.3 percent over the four years ended June 30, 2007, compared to the 66.4 percent gain posted by the S&P 500.
Even better, S&P 500 Industrials Index trades at a slight discount on a price-to-earnings basis. With the exception of a period of extreme economic weakness in 2008 and early 2009, the group’s current valuation relative to the S&P 500 is near the low end of its historical range.
We expect the best performers in the industrial sector to benefit from two secular growth trends that are fueling the US economy: rising domestic energy production and a boom in automobile sales.