Sector Business Cycle Analysis - State Street Global Advisors
InsightsSector and IndustrySector Business Cycle AnalysisMatthew Bartolini, CFAHead of SPDR Americas ResearchAnqi Dong, CFA, CAIASenior Research StrategistThere are different investment approaches to identify sector winners and losers, such as pricemomentum strategies, top-down approaches based on specific macroeconomic indicatorsand bottom-up approaches to identify sectors with improving fundamentals. One widely usedapproach is business cycle analysis. Since economic cycles usually exhibit characteristics thatimpact sectors or industries differently, investors may identify sectors that are favored by thecurrent economic phase.A standalone business cycle-based sector rotation is difficult to implement, as differences existin economic conditions of each cycle over time and transformative technology continues to alterbusiness model and economic impact. However, understanding cycle dependency on sectors isimportant to sector portfolio construction, particularly for a top-down approach.To make a quantitative and systematic assessment of how different sectors performed throughvarious business cycles, we used the Conference Board Leading Economic Indicator Index (LEI)to segregate business cycles and evaluated sector performance over multiple business cyclesbetween 1960 and 2018. This provided a good sample size to evaluate sector performanceconsistency for different cycles.Understandingand DefiningBusiness CyclesThe concept of a business cycle was first introduced by Wesley C. Mitchell and Arthur F. Burns.They took the indicator approach that uses cyclical economic indicators to explore patterns ofeconomic fluctuations.“Business cycles are a type of fluctuation found in the aggregate economicactivity of nations that organize their work mainly in business enterprises:a cycle consists of expansions occurring at about the same time in manyeconomic activities, followed by similarly general recessions, contractionsand revivals which merge into the expansion phase of the next cycle.”—Wesley C. Mitchell and Arthur F. Burns1
First published by the US Department of Commerce as part of the Business Cycle Indicatorsprogram in the late 1960s, the Conference Board’s LEI Index follows this approach by aggregating10 economic indicators (see Appendix II) — ranging from employment, business orders andfinancial conditions to consumer expectations — to summarize common turning-point patternsin economic data. The indicators included in the composite index have survived a wide variety ofstatistical and economic tests, such as consistency, economic significance, statistical adequacy,smoothness and promptness.Most of the research on business cycles defines only recession and expansion throughidentifying peak and trough. However, we believe there are nuances in different stages between apeak and trough. Therefore, we divided the business cycle based on the direction and magnitudeof changes of the Conference Board LEI Index. Recession The LEI Index declines to a trough at an accelerating pace2Recovery The LEI Index rebounds from a trough but below long-term trendsExpansion The LEI Index YoY changes are positive and above long-term trendsSlowdown The LEI Index YoY changes pass the peak and begin moderatingThe chart below shows the delineation between these parts of the cycle:Figure 1Business CyclesSince 1960 RecessionRecoveryExpansionSlowdown Conference BoardLEI YoY %20LEI YoY Change Jan2003Jun2011Nov2019Source: Bloomberg Finance L.P., SPDR Americas Research, as of 11/30/2019.Sector Business Cycle Analysis2
EvaluatingSector PerformanceOver MultipleBusiness CyclesAlthough Global Industry Classification Standard (GICS) sector classification has becomewidely recognized and tracked by market participants, its performance history is limited, goingback to only 1989 and covering only three recessions. To get a comprehensive account of sectorperformance over multiple business cycles, we leverage the performance data of KennethFrench 48 SIC-based (Standard Industrial Classification) industry portfolios based on the latestGICS sector definitions. We then equally weight industry performance to create a longer sectorperformance history that covers seven recession and recovery periods, 12 expansions and11 slowdowns. Appendix I lists the GICS sectors assigned for the 48 SIC-based industry portfolios.In order to fully evaluate sector performance over business cycles, we assess how well the sectorperformed and how consistent the performance is in each type of cycle by using the followingsix metrics:123456Average monthly sector returnAverage monthly sector excess return over the broad market3Average return of the sector over each business cycle4Average excess return of the sector over each business cyclePercentage of months when the sector outperformed the broader marketPercentage of cycles when the sector outperformed the broader marketWe then calculate the sector z-scores based on these metrics to standardize results acrossall sectors and allow for easy comparison. Next, we calculate a composite score by equallyweighting each metric to identify top and bottom three sectors for each business cycle.Four Stages of the Business CycleRecession During a recession, economic activities fall significantly across the board, withdeclining economic outputs and aggregate demand from both consumers and businesses.It features increasing unemployment, low consumer confidence and contractionarydomestic production. Monetary policy attempts to increase aggregate demand by loweringinterest rates and increasing the money supply.Recovery During a recovery, the economy rebounds sharply from the bottom, but belowtrend. GDP growth and aggregate demand accelerate. Consumers become more positiveabout economic growth, start taking advantage of the low interest rates and increase theirdiscretionary spending, while businesses stop cutting back on commercial activities.Expansion Economic growth reaches the cycle peak. Amid rosy economic prospects andincreasing corporate profits, companies begin to allocate capital to expand business andimprove productivity to meet increasing demand. Interest rates start rising from their relativelylow levels.Slowdown Capacity utilization usually reaches cycle peaks and economic output gaps turnpositive, meaning the economy is running beyond full capacity. Limited capacity constrainseconomic growth from accelerating further, leading to positive but decelerating growth.Monetary policy becomes more restrictive to steer the economy away from overheating.Sector Business Cycle Analysis3
Our findings on sector performance during different phases follow:Figure -9.0-7.011.0Hit Rate (% of MonthsOutperforming the Market)49.370.453.553.559.246.547.943.739.460.6Hit Rate (% of PeriodsOutperforming the gregated Z-Score-2.08.34.6-2.05.2-3.4-1.3-8.6-7.76.6Average Monthly Return (%)Average MonthlyExcess Return (%)Average Period Return (%)Average PeriodExcess Return (%)Source: Kenneth French Data Library, SPDR Americas Research, as of November 30, 2019. The top three sectors are shaded in green. The bottom three are shadedin orange.During a recession, as shown in the table above, noncyclical sectors, like Consumer Staples,Utilities and Health Care, performed well, as their business ties to nondiscretionary spendingare less sensitive to economic fluctuations. They outperformed the broader market by anaverage of more than 10% during six of seven recession periods. Real Estate and Technologyare among the worst-performing sectors across all the metrics. As their business ties to highlydiscretionary spending from both consumers and businesses, these sectors tend to be the first toexperience spending cuts during periods of diminishing income and business activities.Figure litiesAverage Monthly Return (%)3.41.92.82.42.32.93.03.63.01.6Average MonthlyExcess Return (%)1.1-0.30.60.10.00.60.71.30.7-0.6Average Period Return (%)33.118.027.123.121.427.429.339.228.414.7Average PeriodExcess Return (%)12.0-3.06.02.00.06.08.018.07.0-7.0Hit Rate (% of MonthsOutperforming the Market)64.543.553.254.846.856.561.358.153.245.2Hit Rate (% of PeriodsOutperforming the -7.50.8-1.5-4.12.23.87.22.3-9.1Aggregated Z-ScoreSource: Kenneth French Data Library, SPDR Americas Research, as of November 30, 2019. The top three sectors are shaded in green. The bottom three are shadedin orange.Sector Business Cycle Analysis4
In a recovery phase, improvement in the labor market and consumer confidence leads toincreases in discretionary spending on restaurants, travel and durable goods,5 benefitingConsumer Discretionary sectors. While recessions tend to hit the real estate market hard, thelow interest rates and easing monetary policy following the recession make it cheaper and easierto purchase real estate. The recovery in commercial activities also lifts the value of commercialreal estate, contributing to the Real Estate sector’s outperformance. The outperformance ofConsumer Discretionary is more consistent than that of Real Estate, given its higher hit rateon both a monthly and periodic basis. On the other hand, sectors that are favored during therecession — Consumer Staples, Utilities and Health Care — lose their attraction as themarket rebounds and investors embrace more cyclical sectors to capture upturns in the market.Figure ilitiesAverage Monthly Return (%)1.40.91.21.71.01.41.21.51.80.7Average MonthlyExcess Return 03.06.0-8.0Hit Rate (% of MonthsOutperforming the Market)50.747.347.858.047.351.746.851.751.741.5Hit Rate (% of PeriodsOutperforming the 4.7-0.98.0-5.02.1-1.93.37.6-10.3Average Period Return (%)Average PeriodExcess Return (%)Aggregated Z-ScoreSource: Kenneth French Data Library, SPDR Americas Research, as of November 30, 2019. The top three sectors are shaded in green. The bottom three are shadedin orange.The expansion phase features narrow sector dispersion, as economic growth accelerates to itspeak and more sectors benefit from the economic boom. Market returns are at their second bestduring this phase, following behind the recovery phase, but the duration of this phase tends to belonger. During this phase, capacity utilization tends to increase significantly, to its peak, as shownin Figure 5.Businesses feel more confident about their growth prospects and start expanding, allocatingmore capital to improve productivity, such as investing in Technology. Interest rates also startmoving up from very low levels. Increasing loan volume and higher interest rates tend to benefitFinancials. Technology’s and Financials’ outperformance is quite consistent, as they beat themarket in 10 out of 12 expansion phases. Noncyclical sectors continue to be out of favor duringthe economic expansion phase.Sector Business Cycle Analysis5
Figure 5US CapacityUtilization DuringExpansion Phases95% of Total Capacity9085ExpansionCapacity ar1997Sep2004Apr2012Nov2019Source: Bloomberg Finance L.P., SPDR Americas Research, as of 11/30/2019.Figure 111.8Average PeriodExcess Return (%)-5.04.0-2.04.05.02.0-4.0-8.00.02.0Hit Rate (% of MonthsOutperforming the Market)46.957.951.448.054.253.148.344.748.950.3Hit Rate (% of PeriodsOutperforming the gated Z-Score-5.48.1-0.30.57.33.8-3.8-10.8-0.91.4Average Monthly Return (%)Average MonthlyExcess Return (%)Average Period Return (%)Source: Kenneth French Data Library, SPDR Americas Research, as of November 30, 2019. The top three sectors are shaded in green. The bottom three are shadedin orange.As economic growth decelerates and input costs increase, corporate profitability growth comesunder pressure, remaining positive but slowing down. Given capacity and efficiency constraints,companies spend more on capital expenditures to meet demand, but there is usually a lagbetween the deployment of capex and rising productivity. The overall market return is at itssecond worst during this phase. Investors start positioning more defensively and reducing theirallocation to economically sensitive sectors in anticipation of the next economic downturn. Thisleads to the outperformance of Health Care and Consumer Staples and the underperformanceof Consumer Discretionary and Real Estate. Industrials is the third-best-performing sector,as it benefits from increasing investment in capital products. However, increases in capex did notoccur or were not significant every time economic growth slowed. As shown in Figure 7, duringthe 1984–1989, 2014–2016 and 2019 slowdowns, private nonresidential fixed investment declinedsignificantly, leading to Industrials’ underperformance in all three periods.Sector Business Cycle Analysis6
Figure 7Private NonresidentialFixed Investment DuringSlowdown PhasesSlowdown30Change from a Year Ago (%)2010 Private NonresidentialFixed 90Jul1997Nov2004Mar2012Jul2019Source: Bloomberg Finance L.P., SPDR Americas Research, as of 09/30/2019.OutliersFigure 8CommodityPrices DuringBusiness Cycles RecessionMaterials and Energy are commonly expected to perform well during a slowdown, as thepositive output gap during this phase tends to lead prices of oil and basic materials higher andcontribute to profitability. However, as these markets have become more integrated with theglobal market, the boom of commodity prices during US economic slowdowns has occurred lessfrequently since the 1980s.1,000Index Level800600RecoveryExpansionSlowdown400GSCI Commodity Index GSCI Industrial MetalsSpot Index GSCI Energy Spot 1May2007Aug2013Nov2019Source: Bloomberg Finance L.P., SPDR Americas Research, as of 12/31/2019.Sector Business Cycle Analysis7
Energy did not make the top/bottom three sectors during any business cycle, indicating it maynot be as sensitive to US economic cycles as most people think it is. Energy company profitabilityis directly tied to oil prices. Given the fungibility of the industry outputs and highly connectedglobal commodity market, energy firms’ profits are more driven by the oil supply and demandworldwide. Since OPEC member countries produce approximately 40% of the world’s crudeoil and oil exports represent 60% of the total petroleum traded internationally, OPEC’s actionshave significant influence on global oil prices,6 impacting US energy firms’ profits. Furthermore,geopolitical tensions can play a big role in OPEC’s actions, introducing more idiosyncratic risksto the sector. For example, the oil embargo imposed by Arab producers against the westernworld in 1973, the Gulf War in the 1990s and, more recently, Venezuela’s oil crisis all impacted themarket. Also, the supply glut in 2015 caused by the adoption of fracking technology shocked theenergy market, weighing down energy stocks while the broad economy was slowing down.Materials Firstly, negative idiosyncratic industry events coincided with certain slowdownperiods. In the 1990s, the emergence of state-controlled chemicals and mining companies indeveloping countries undercut US producers and miners’ market shares and pricing power.In 1997–1998, the Asia/EM financial crisis reduced global demand for metals and mining products.Traditional metals and minerals exporters, such as Russia and Brazil, turned to the US — wherethe economy was more insulated from the crisis — to dump their extra capacity. Even thoughUS demand of basic materials was strong in the late stage of expansion, metal prices droppedby 25% because of the flood of foreign supply, sending metal & mining stocks down by 21%,compared with a positive return of 43% for the S&P 500 Index, as shown in Figure 9.Figure 9Metal Prices vs.Metal & MiningIndustry RelativePerformance Duringthe 1997–1999Economic Slowdown S&P 500 Metals &Mining IndustryIndex / S&P 500 Index S&P GSCI IndustrialMetals Spot Index0.16Relative PerformanceS&P GSCI Industrial Metals Spot 1997Jun1997Nov1997Apr1998Sep1998Mar1999110Source: Bloomberg Finance L.P., SPDR Americas Research, for the period from Nov. 1, 1997 to Mar. 31, 1999.Secondly, given that only 15% of the US GDP is contributed to by goods-producing industries,compared with 80% by service-producing industries, the US economy has become moreservice-based and less reliant on resource-intensive production. The shift of the globalmanufacturing center to Asia drove flows of natural resources to that region. Therefore,Materials may have become less sensitive to the overall US economic cycles but moreimpacted by global economic conditions.Sector Business Cycle Analysis8
Establishing aSector Roadmap forBusiness CyclesBelow are the 11 GICS sectors’ aggregated z-scores based on the six metrics. Given that thenew Communication Services consists of former Technology, Consumer Discretionary, andTelecommunication stocks, we calculated its z-score as the weighted average of the threesectors’ z-scores.Figure 10Sector Z-Scores forBusiness essionSource: SPDR Americas Research, as of November 30, 2019. The top three sectors are shaded in green. The bottom three are shaded in orange.Based on the z-scores above, we created the sector road map below to show sector positioningin different part of the business cycle.Figure 11A Sector Roadmapfor Business CyclesExpansionSlowdownRecessionRecovery Growth reaches its peak Capacity utilization peaks Declining economic outputs Economy rebounds but below trends Increasing capex to improveproductivity and meet increasingdemand Positive output gaps Falling demand from bothconsumers and businesses Consumer expectations improve Interest rates start rising from theirrelatively low levels Positive but decelerating growth More restrictive monetary policy Increasing unemployment Low consumer confidence Discretionary spending increases Businesses stop cutting back oncommercial activities Easing monetary policy M onetary policy remainsaccommodative nologyCommunication ServicesConsumer StaplesHealth CareUtilitiesConsumer StaplesHealth CareIndustrialsMaterialsConsumer DiscretionaryReal EstateConsumer StaplesUtilitiesHealth CareCommunication ServicesReal EstateTechnologyConsumer DiscretionaryReal EstateMaterialsHealth CareConsumer StaplesUtilitiesSource: SPDR Americas Research, as of 12/31/2019. /-- indicates the two best/worst-performing sectors. /- indicates the third-best/worst-performing sectors.For illustrative purposes only.Sector Business Cycle Analysis9
The above sector business cycle analysis provides a general view on how sectors perform duringdifferent parts of the economic cycle. Unique characteristics and the idiosyncratic nature of eachcycle warrants individual anal
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