Investors in both India and the US are exhibiting a cautious stance, prioritizing defensive sectors over cyclical or high-growth stocks. This shift reflects broader concerns about policy uncertainty and global market volatility, though the underlying reasons for the trend differ between the two markets. Global funds have withdrawn over $7 billion from Indian equities this month, exacerbating the supply-demand imbalance. While DIIs have stepped in aggressively to buffer the impact of these outflows, their efforts may not be enough to sustain market momentum.

Contrary to the conventional belief that high-quality stocks, characterized by strong return on equity, sustainable margins, and consistent earnings growth, will always lead in long-term performance, cyclical stocks have outpaced their quality counterparts during specific periods. This shift is evident when examining performance data from March 2020 through March 2024.

Relationship Between Defensive and Cyclical Stocks

Defensive stocks are those that remain stable and maintain demand regardless of the broader economic conditions. They are typically found in industries that produce essential goods or services, such as utilities, healthcare, and consumer staples. These companies provide products or services that people need no matter the state of the economy, so their revenues and profits tend to be more stable. Cyclical stocks, on the other hand, are highly sensitive to economic cycles. They tend to perform well during periods of economic growth and suffer during downturns. Cyclical industries include sectors like automobiles, construction, travel, and luxury goods. These industries thrive when consumer confidence and spending are high but struggle during recessions as people cut back on discretionary spending.

Defensive and cyclical stocks are inversely related in terms of performance during different phases of the economic cycle. This relationship makes them valuable tools for diversifying a portfolio.

1. Counter-Cyclical Protection:

• During economic downturns, investors often turn to defensive stocks for their stability and steady returns. Since cyclical stocks tend to underperform during these periods, defensive stocks can act as a buffer, helping reduce the overall risk in a portfolio.

• Conversely, during economic expansions, cyclical stocks typically outperform, while defensive stocks may lag. Therefore, balancing both types of stocks ensures that the portfolio can capture gains during booms while providing stability during busts.

2. Risk Mitigation Through Diversification:

• A well-diversified portfolio that includes both defensive and cyclical stocks can offer the best of both worlds—growth potential during economic booms and protection during downturns. This approach minimizes the risks associated with putting all investments into one type of stock.

• For investors with a long-term perspective, maintaining a mix of these stocks can smooth out returns over time and protect against the inherent volatility of cyclical sectors.

3. Asset Allocation Strategy:

• Investors often adjust their allocation between defensive and cyclical stocks based on their economic outlook. In times of uncertainty or expected recession, they might increase their holdings in defensive stocks to preserve capital. During times of economic optimism, they may shift towards cyclical stocks to maximize potential returns.

• This tactical allocation is particularly useful for investors who are more actively involved in managing their portfolios and can shift their weightings based on changing economic indicators.

Outperformance of Cyclical Stocks: Lessons from Recent Bull Markets

Between March 2020 and March 2024, cyclical stocks delivered an impressive 77% annualized returns, with earnings growing at 9.8x. Quality stocks, by comparison, yielded lower returns of 30% and a CAGR of 2.8x. This remarkable performance contrasts sharply with the period from 2014 to 2020, where cyclical stocks underperformed quality stocks, falling by -10%, compared to an 8% rise for quality stocks. Despite the volatility, cyclical companies rebounded strongly, driven by broader economic recovery and increased consumer demand in sectors like construction, commodities, and travel.

Long-Term View: 21-Year Performance of Cyclical and Quality Stocks

Looking at the broader period from 2003 to 2024, cyclical and quality stocks have delivered nearly identical returns—both at 21% CAGR. This challenges the assumption that quality stocks are inherently superior over long-term horizons. While quality stocks have generally demonstrated more consistent earnings, cyclical stocks have leveraged valuation reratings to close the gap in earnings growth.

For example, cyclical companies have seen a 53.9x rise in earnings growth between 2003 and 2024, compared to a 58.6x rise for quality companies. Although quality companies displayed superior earnings, cyclical stocks managed to outperform due to favorable market conditions and strong recovery periods following economic downturns.

Risks and Volatility in Cyclical Stocks

Despite their recent outperformance, it’s important to remember the inherent risks associated with cyclical stocks. For instance, from 2008 to 2020, cyclical stocks experienced a negative CAGR of -9%, reflecting their vulnerability during recessions and periods of economic instability. In contrast, quality companies managed a positive CAGR of 8% over the same timeframe, underscoring their relative stability.

This volatility highlights the importance of entry points and timing when investing in cyclical stocks. Cyclical stocks are often subject to extended periods of underperfmance, followed by rapid, concentrated bursts of growth. For fund managers, this can be challenging, as prolonged downturns can erode client confidence and investment returns.

Now let’s look at the US & Indian economy to see whether there is a sector rotation happening along with a preference for defensive stocks over cyclical stocks.

Defensive Strategy Among Slower US Stocks Growth

Explosive rally in US stocks over the past 5 years is tapering off. While the stock market has nearly doubled in value during this period. There is a growing sentiment among market watchers who believe that the factors that propelled the S&P 500 to record highs may be running out of steam. The recent artificial intelligence frenzy, one of the main contributors to the stock market rally, is beginning to face scrutiny, and some investors are raising doubts about its long-term impact on stock valuations. Additionally, the upcoming U.S. presidential election in 2024 could further test investor optimism.

Headwinds vs. Positive Forces

Several negative headwinds could weigh on the market in the near term, including:

• High valuations: Many stocks, particularly those in the technology sector, are trading at elevated multiples, which could limit future gains.

• Geopolitical risks: Ongoing geopolitical tensions, including conflicts and trade disputes, pose potential risks to global markets.

• Unsustainable government deficit: The growing U.S. fiscal deficit could lead to increased borrowing costs or future austerity measures, affecting economic growth.

On the positive side a few factors that could support the market:

• Inflation nearing the Fed’s target: With inflation levels cooling down, the Federal Reserve may have more flexibility in its monetary policy, which could stabilize markets.

• AI investment spending: While the AI frenzy is being questioned, investment in AI technology still presents long-term growth potential.

Among the more significant risks, the potential for increased corporate taxes if Kamala Harris wins the U.S. presidential election and her party takes control of Congress in November. This, along with recent reports of Warren Buffett hoarding a record amount of cash, serves as a warning of a “bumpy road ahead”.

Opportunities in US Emerge in Underinvested Cyclical Sectors

Investors are continuing to position themselves in defensive trades despite the underlying strength of the US economy, according to Morgan Stanley. In a recent note, the firm spotlighted opportunities in cyclical sectors, particularly financials, which it upgraded to "overweight" relative to defensive sectors.

Morgan Stanley noted that financials have been the most under-owned sector, with net exposure ranking in the bottom 15th percentile of data going back to 2010. Several catalysts could drive financial stocks higher in the near future.

1. Rebounding capital markets activity – As capital markets recover, financial institutions are expected to benefit from increased transaction volumes and business activity.

2. Improved loan growth environment in 2025 – Loan growth is projected to strengthen, providing a tailwind for banks and lenders.

3. Acceleration in share buybacks post Basel Endgame re-proposal – Regulatory clarity surrounding Basel Endgame has opened the door for financial institutions to resume or accelerate share repurchases, which can boost stock prices.

4. Attractive relative valuations – After last month’s de-risking, bank stocks, in particular, have more appealing valuations. Large-cap dealers had previously cautioned about the sector’s operating environment, pushing valuations lower, but this has created an environment where it’s easier for lenders to outperform investor expectations.

Despite strong earnings and attractive valuations, investor appetite for financials and other cyclical sectors remains limited. Broader market exposure continues to be concentrated in defensive sectors, such as utilities, healthcare, and real estate, which are traditionally seen as safer bets during periods of economic uncertainty. The reluctance to move into cyclicals shows that many investors are still preparing for a soft-growth scenario, even though recent macroeconomic data suggests otherwise. Several key data points, such as the stronger-than-expected September jobs report and the ISM Services Index, indicate that the US economy is faring better than expected.

Sector Rotation In India From Cyclicals & Modi Stocks to Defensive Stocks

In September in India, stocks previously expected to benefit from Prime Minister Narendra Modi's re-election had underperformed, as investors increasingly favor defensive sectors like consumer and technology. While an index of so-called "Modi stocks" had only climbed 2% since Modi began his third term in June, consumer and software stocks have surged by 20% and 34%, respectively.

A few recent policy reversals and uncertainty regarding the government's next steps have caused investors to rethink their exposure to sectors reliant on government spending, such as infrastructure. Modi's government has withdrawn key policies, including hiring market experts for senior positions and delaying broadcasting reforms, adding to the uncertainty.

There is a pronounced shift in focus from infrastructure to agriculture and consumer sectors. This rotation, compounded by global market volatility and post-election dynamics, has further dampened investor interest in "Modi stocks."

There are concerns that the government may miss its capital expenditure targets. Such a shortfall could be detrimental to infrastructure companies that have enjoyed government investment in recent years. However, domestic and foreign funds are now cutting exposure to capital goods, utilities, cement, and financial sectors.

This rotation into defensive stocks is seen as a risk-off response to growing global economic uncertainties. Factors such as warning signs of a slowdown in the U.S., stagnation in China’s economic policies, and the continued weak performance of the Eurozone have pushed investors toward more stable, fundamentally-driven sectors. The preference for defensive themes reflects caution, as these sectors typically offer more consistent earnings and less volatility during uncertain periods.

Record IPOs Supply Add to Market Overhang

On Thursday, Hyundai Motor India raised $3.3 billion in the country's largest IPO, adding to the already significant supply of shares entering the market. According to data from primedatabase.com, IPOs worth an additional $6 billion have been approved by regulators, further contributing to the supply glut. With Hyundai’s IPO proceeds, Indian IPOs have raised more than $12 billion in 2024, surpassing the volumes of the past two years.

Adding to this influx are share sales by company founders totaling $25 billion — the most in at least five years — along with institutional placements exceeding $11 billion. The sheer volume of these offerings is weighing on market sentiment, particularly as the broader market contends with weak corporate earnings.

Historical data suggests that large share sales often coincide with market peaks. Company founders are capitalizing on high equity valuations by selling to institutions. Although domestic investors are absorbing much of the supply, there is still reason for caution. However, history indicates that large IPOs have mixed results, with only two out of five IPOs worth at least $2 billion since 2007 — DLF and Coal India — delivering positive returns within a month of listing. Additionally, mega IPOs are often associated with market peaks, followed by declines in broader indices.

Key Themes For The Next Few Months In India

Key Numbers:

• India’s Private Credit Firms Drive First $10 Billion Year: Private credit is booming, and Indian firms are capitalizing on it.

• Wall Street Trader Bonus Hopes Rise: Big banks’ success has led to swelling expectations for bonuses in 2024.

• The Auto Industry's Fear of BYD’s Cheaper EVs: Global automakers are increasingly concerned about BYD's aggressive push with affordable electric vehicles.

Festive Demand: Crucial Test for Growth

India's festive and wedding season will play a pivotal role in determining company earnings and broader market sentiment. Investors are optimistic that these events will drive a revival in demand. However, experts caution that if consumer spending fails to meet expectations, it could lead to further downgrades in earnings forecasts. This could make Indian stocks less appealing compared to other Asian markets, such as China, Japan, and Taiwan. The MSCI India index has already lagged behind the broader Asian gauge this month, as foreign investors increasingly turn their focus towards China.

Rice Sector: Betting on a Basmati Boom

One sector that stands out amidst concerns over consumer demand is rice, particularly specialty varieties like basmati and jasmine rice. With shifting consumer preferences, demand for these premium types of rice is surging. India, which controls three-fourths of the global basmati rice market, is well-positioned to benefit. Rice companies are expected to gain further, especially after the government recently removed the minimum export price on basmati, allowing these firms to expand their market presence.

Chemical Makers: Mixed Signals

Indian chemical companies are receiving mixed signals as they navigate a challenging environment. According to a report from Centrum, production levels in Europe are steadily improving, which is positive news for Indian chemical exporters. However, despite recent increases in exports, the recovery remains erratic and lacks clear signs of long-term sustainability.

Credit Growth: Slowdown in Bank Loans

Elevated interest rates are beginning to dampen demand for bank loans, with credit growth slowing to 13% year-over-year as of September 20, compared to 20% at the end of 2022. According to Sujan Hajra, chief economist at Anand Rathi Share & Stock Brokers, the decline is being driven by a slowing economy and high borrowing costs. Hajra expects loan growth to remain in the 12%-15% range over the next year, further constrained by weak deposit growth.

Market Outlook: A Volatile Path Ahead

The surge in IPOs and institutional share sales, coupled with slowing corporate earnings and heavy foreign outflows, suggests a challenging road ahead for Indian equities. While domestic institutional investors are attempting to cushion the blow, their efforts may not be sufficient to prevent further downside, especially if global economic headwinds persist.

As Indian stocks continue to see significant new supply from IPOs and institutional sales, market participants should brace for potential volatility and prepare for possible corrections in the near term. Given the market's historical performance following large IPOs, investors may need to approach this period with caution, keeping an eye on the fundamental backdrop and the broader global environment.