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Key points

  • Market cycles –performance trends that occur during different phases of the business cycle – have a significant influence on stock and bond prices. Understanding that impact can be critical to portfolio construction.
  • Sector and factor rotations present investors two potential approaches to seek outperformance of the broader market across market cycles.
  • We offer a framework for investors to consider to help them implement sector and factor rotation strategies in today’s market environment with three scenarios: a base case, a bear case and a bull case.

Surf’s up: Market cycles

It is important first to understand how different phases of the business cycle affect companies. For example, the “early cycle” phase is characterized by rising bond yields, easing credit conditions, and accelerating growth. This, in turn, historically has supported cyclical equity sectors and pro-growth factors, such as value and size.

In contrast, the “late cycle” phase is characterized by an inverted yield curve, rising credit market stress, and decelerating growth, which historically has supported less economically sensitive sectors, such as consumer staples, and companies with high quality balance sheets. Figure 1 describes how economic activity and asset performance has varied over the business cycle.

Figure 1: A full market cycle

Figure 1: A full market cycle


Early CycleMid CycleLate CycleRecession
  • Growth recovers
  • Inflation still easing
  • Policy rates trough
  • Rising yields, steeper curve
  • Credit spreads fall, defaults peak
  • Equities recover
  • Growth broadens
  • Inflation starts to rise
  • Easy monetary policy, tightening starts
  • Yields inch higher, curve shifts up
  • Credit tightens further, defaults fall
  • Equity bull market
  • Capacity pressures bite
  • Growth peaks
  • Inflation rises above target
  • Policy rates rise above neutral
  • Curve flattens, inverts
  • Credit spreads widen, defaults trough
  • Equities recover
  • (Growth) recession
  • Deflationary pressures
  • Monetary policy eases
  • Safe haven bid
  • Bond yields fall
  • Equity bear market
  • Credit spread widen, defaults rise

Source: BlackRock, the US National Bureau of Economic Research, with data from Thomson Reuters, April 2019. Notes: The chart shows an estimate of the US output gap (GDP as a percentage of potential GDP). We have classified different time periods as belonging to certain stages of the business cycle. The classification of the stage is done via a “cluster analysis” that groups together time periods where economic series have behaved in similar ways. Measures of economic slack, wage and price inflation, the stance of monetary policy and the growth of leverage in the private sector are used in this analysis.

Reading the waves: Grouping securities

Investors have long sought to categorize securities to capture common characteristics that reflect how those assets react to the various stages of a market cycle. Two common such approaches are sectors and factors.

The more traditional approach, sector investing is based on grouping companies by their principal business activities. One of the most widely used classifications is the Global Industry Classification Standard (GICS), which divides the investment universe into sectors, industry groups, industries and sub-industries.

A newer approach, but one based on longstanding insights into the markets and their underlying dynamics, is by using factors – that is, grouping securities by characteristics that reflect recognized drivers of long-term return. Factors include cheaper stocks (value) or smaller market cap stocks (size), stocks that are trending (momentum), stocks with stronger balance sheets (quality), and stocks with low volatility (min-vol).

In this paper, we take no position on whether investors should utilize a factor or sector approach. We believe investors should use the grouping method that works with their overall approach to building portfolios. Academic research using 40 years of market data suggests1 that each of the factors listed above historically have outperformed the broad market if held over the long term, which has not always been the case for sectors. However, sectors are more intuitively understood and explained, and may allow investors to more directly target specific themes.

Catching the waves: Pinpointing where are we in the cycle

Whether investors use sectors or factors to tilt their portfolios, the threshold question that makes market tilting challenging is knowing where we are in the economic cycle. Given the macro uncertainty, we offer a framework to discuss our current market outlook in three scenarios: a base case, a bear case and a bull case. We highlight ideas to implement those macro views with sector and factor strategies.

Base case

Our base case for 2019 is that the U.S. economy is entering a late-cycle phase. The BlackRock Growth GPS has been trending lower across the U.S. and eurozone, pointing to a slower pace of growth in the 12 months ahead.

Figure 2: BlackRock Growth GPS for the U.S, 2010-2019
U.S. future GDP growth implied by BlackRock GPS vs. consensus estimates

Figure 2: BlackRock Growth GPS for the U.S, 2010-2019

Source: BlackRock Investment Institute with data from Bloomberg, April 2019. The BlackRock Growth GPS shows where the 12-month forward consensus GDP forecast may stand in three months’ time.

As the economy moves beyond the peak of the cycle into a slowdown regime and the probability of market shocks increases, we advocate for caution and tilts towards higher quality exposures. Analysis points to outperformance of defensive sectors and factors relative to cyclical exposures in a slowing but still growing economy.2

Therefore, we like sectors with strong balance sheets and that have displayed resilient earnings such as health care and technology. Alternatively we prefer the quality factor to seek higher returns, or minimum volatility to specifically dial down potential risk.

Bull case

While economic growth is slowing across regions globally, we see U.S. growth stabilizing at a much higher level than other regions, even as the effects of domestic fiscal stimulus fade. Improved financial conditions could potentially boost capital expenditure and investor sentiment could be supported by improved global growth. We could potentially see another year of 3% growth in the U.S. and a bid for risk assets to continue.

In this scenario, investors should consider staying with cyclical exposures such as technology, consumer discretionary, and momentum factors. Continued economic expansion means growing loan demand and declining default rates that would support high growth sectors such as technology and communication services. Similarly, as momentum is the most correlated with economic growth, we think momentum would have room to run in a pro-growth environment.

Bear case

A more drastic slowing of economic growth and rising geopolitical uncertainty would trigger a more bearish positioning. If recession hits earlier than the market is currently pricing, defensive exposures will provide more downside protection for portfolios.

In troubled times, consumers tend to reduce spending on “nice to have” items before stopping to use electricity, gas or water. Therefore, utilities and consumer staples companies have historically outperformed sectors like consumer discretionary during economic downturns. Through a factor lens, the minimum volatility factor historically has experienced the lowest drawdowns during volatile market conditions. For example, in the market drawdown over the course of Q4 2018, minimum volatility outperformed momentum and value by more than 10%.3 Though the drawdown-reducing potential of minimum volatility strategies is clear, aggregate active factor exposures across all U.S. active equity mutual funds indicate that investors have been consistently under-invested in minimum volatility factor exposures in the past two decades.4


Market cycles have a significant impact on asset class performance. To take advantage of those long-term price patterns, investors need to recognize the current market cycle regime they are in, as well as the market opportunities presented before them. Figure 3 below provides a combined conceptual framework for sector and factor tilting. Both approaches provide valuable tools for investors to consider to tilt portfolios and seek potential outperformance.

Figure 3: A combined framework for sector and factor tilting

Figure 3: A combined framework for sector and factor tilting

Source: BlackRock, as of 5/1/2019. For illustrative purposes only.

Summary Table

ScenarioMarket cyclesJustification/catalystOur sector preferenceOur factor preference
Bull Mid-Cycle Stabilized growth, improved financial conditions and investor sentiment Technology, consumer Discretionary Momentum
Base Late Cycle Slower U.S. GDP growth Healthcare, technology Min vol, quality
Bear Recession Drastic growth slowdown, rising geopolitical uncertainty Utility, consumer staples Min vol
Christopher Dhanraj
Head of iShares Investment Strategy
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