Cyclical stocks, value shares and small caps have led European and US markets so far this year in a pattern that has surprised many investors, but JP Morgan’s equity strategy team says the rally may be running ahead of economic reality.
Strategist Mislav Matejka noted that the outperformance of economically sensitive stocks over their defensive counterparts has persisted even against the backdrop of the Iran conflict, a development he said many market participants find counterintuitive.
Cyclical stocks are those whose fortunes are closely tied to the health of the broader economy, such as industrials and materials, while defensive stocks, including utilities and healthcare, tend to hold up better during downturns.
The bank said the cyclical leadership holds true in both Europe and the United States, even when the distorting effect of large technology and artificial intelligence stocks is stripped out of the comparison.
However, JPM flagged a growing divergence between share price performance and underlying economic data that could signal a tactical pause in the rally.
European cyclicals versus defensives are trading at highs, while purchasing managers’ indices, a closely watched gauge of manufacturing and services activity, have softened, creating a gap that the bank said represents a near-term headwind.
Market breadth has also narrowed sharply, with the proportion of stocks outperforming on a three-month basis hitting fresh lows in both the US and Europe, suggesting the rally is being driven by a shrinking number of names.
JPM entered the year positioned long on value, small caps and cyclicals in its international portfolios and said it still sees upside for value in Europe on valuation grounds.
The picture is less clear in the United States, where the small-cap and value rally reversed after the Iran conflict began, and the bank has instead favoured the so-called Magnificent Seven mega-cap technology stocks since March.
For investors looking to rotate defensively in the near term, JPM highlighted utilities, consumer staples and pharmaceuticals as areas that could perform well, and published a list of de-rated defensive names alongside cyclicals that have run particularly hard.
Looking further out, the bank said that if its constructive macroeconomic view plays out and geopolitical risks subside in the second half of the year, cyclicals are likely to resume their leadership, potentially broadening to include consumer discretionary stocks, the one cyclical laggard so far this year.
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