Cyclicals Bear the Brunt of Volatility

By Greg Woodhams - October 24, 2018

Another day, another volatile trading session amid worries about trade, geopolitical tension and slowing global growth. Though we've been talking about these issues for weeks, corporate earnings season is helping to bring them into focus.

Industrials were among the hardest hit in Tuesday's trading, highlighted by Caterpillar and 3M, which disappointed analysts with their guidance on future earnings. Profits at both companies—and industrials broadly—are under pressure as inflation and tariffs push their costs higher. Companies in the economically sensitive materials sector also fell. More defensive areas, such as consumer staples and communications services sectors were positive.

In the late stages of an economic cycle, costs rise as resources, supply chains and labor pools are stressed. This is an incremental headwind for profit growth, even when sales are growing. Cyclical companies have significant exposure to these late-cycle pressures since a greater portion of their costs are subject to inflation. In contrast, they don't face the same pressures in the early stages of an economic cycle.

As I pointed out in a previous post, investors are reluctant to pay a premium for earnings that may not be sustained if the economy slows or falls into recession. And, since it's difficult to accurately predict the beginning of a recession, cyclical stocks may begin lag long before it arrives.

Companies exhibiting secular growth, on the other hand, may benefit from underlying competitive advantages that are not dependent on the economic cycle. Therefore, strong secular growth companies may outperform later in the cycle due to expectations their earnings growth can continue even as the economy slows.

While we aren't predicting a recession here, the Federal Reserve has made a clear statement that the economy has moved beyond the accommodation phase. This implies we have moved into the late stage of the economic cycle. Shifts like this bring volatility.

Investors should view the volatility of recent weeks as normal, rather than as an aberration. At the same time, they should take the long view and use these periods to align their portfolios with their risk tolerance and investment time horizons.

Greg Woodhams
Global Growth Equity
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