While cyclical sectors retain a considerable performance lead over defensive sectors on the year, their relative performance in August and September is showing signs of stalling, leading some investors to question whether the best days are behind for the group and that a rotation into defensives may prove to be more than simply a ripple.

While we acknowledge that cyclicals may get knocked around in the weeks until Q3 earnings season kickoffs, we caution against jumping into defensives even as their relative valuations are attractive as the balance sheet health of many defensive sectors remains in question.

Fear Factor
• Cyclicals are beating defensives by 11.61% through September 24 with April’s 6.56% of outperformance leading to a sizable portion of that delta. More recently, defensives have outperformed in the last two months as negative news around trade and fears of economic contraction permeate investor psyche.
• Year-to-date results highlight that cyclicals have been more volatile than their defensive peers thanks to market leaders like tech seeing robust results in up months, but sharp drawdowns in down months like May only leading to continued strength as markets absorb the news and go back to focusing on fundamentals and the macroeconomic environment.

Cyclicals Retain a Sizable Lead over Defensives

Source: MSCI, as of September 24, 2019. Cyclicals represented by the MSCI USA Cyclical Sectors Index and Defensives represented by the MSCI USA Defensive Sectors Index. One cannot invest directly in an index. Past performance is not indicative of future results.

Follow the Money?
• Q4 2018’s massive outflows from cyclical sectors looks sharply out of place as flows this year have been considerably more modest both in absolute terms and relative to one another with defensives seeing $2.44 billion more net flows than cyclicals in Q1 and a $2.85 billion spread in favor of cyclicals in Q2 as positioning flip-flopped.
• In the most recent month, investors have moved away from both cyclicals and defensives (implying a broader retracement in overall equity exposure) with defensives seeing marginally less outflows even as cyclicals have a 0.91% lead over defensives. Year-to-date, a mere $268 million differentiates the two groups.

Flows into and out of Sector ETFs have cooled off

Source: Bloomberg Finance, L.P., as of October 1, 2019 to September 24, 2019. Data represents the quarterly net flows of U.S.-listed U.S. Cyclical Sector ETFs and U.S. Defensive Sector ETFs specifically targeting exposure to sectors defined by MSCI as Cyclicals and Defensives, respectively. Past performance is not indicative of future results.

What’s Next?
While investors have become accustomed to dealing with headlines from the trade war to conflicting economic data, they now have an impeachment inquiry of President Trump to digest. While there is historical precedent for impeachments on market performance, its forecasting ability may be nil this time around with the impeachment’s impact likely greatest in an indirect way on negotiating positions with the U.S.-China trade talks. Of course, investors are somewhat numb to calls for impeachment over the last for the last two and a half years.

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