The coronavirus pandemic has dominated news flow throughout 2020. Looking forward, even after the first acute phase of the pandemic has passed, its imprint on our economy and indeed on the very fabric of our lives will likely be prolonged and profound. From an economic standpoint, the Covid-induced recession has already entered the history books as the shortest but sharpest on record. 
We are now embarking on a new business cycle. In our view, this is a cause for optimism – both for the economy and for asset returns – but the unusual cause of the recession, and the unprecedented response to it from policymakers, means we should be thoughtful in how we apply the “early cycle playbook” this time around.
Although the recession and subsequent rebound happened at lightning speed, we see similarities to the market topography of previous cycles; but are mindful of some unique characteristics driven, in part, by the extraordinary level of policy intervention.
The classic early cycle playbook suggests that as a new business cycle begins, rates are low but yield curves are steep. Credit spreads are wide but tightening quickly, safe-haven currencies are starting to sell off, and stocks are cheap but rallying hard, typically led by beaten up cyclicals and value sectors.
Today rates are certainly low but curves are rather flat. Credit spreads are doing largely as expected – especially now that the Federal Reserve is a buyer of last resort in credit markets – and the trade-weighted dollar is down 10 per cent from its summer peak. Stocks did rally very quickly, but with unusual leadership at a sector and style level.
Some cyclical sectors have performed strongly, but others, especially financials, have lagged. Moreover, growth sectors like technology, which are expensive and have led the market higher for some years, extended their outperformance through the crisis.
Cyclicals don’t equal value
In the past, cyclical stocks have been highly correlated with value stocks. However, in the aftermath of the stock drawdowns associated with Covid-19, cyclicals have recovered sharply vs defensives, while value has struggled against growth.
While there is a historical correlation between value and cyclical stocks, we shouldn’t expect it to apply at a time when interest rates are depressed, yield curves are flat, and energy prices are low. Both sides of the value vs growth trade have worked against the pair this year. On the value side, financial companies have been hit hard by the reduction in economic activity associated with Covid-19, the broadly deflationary impulse of the crisis, and the sense that banks are exposed to considerable default risk from companies currently receiving government support. At the same time, energy companies have struggled amid lower oil prices. On the growth side, technology stocks reflected the group’s earnings resilience and their increased relevance as working styles and social interactions changed dramatically during the pandemic.
The cyclicals vs defensives trade has told a different story, though. Cyclicals – notably industrials, materials and consumer discretionary stocks - have captured the rebound in economic activity. Defensives, like utilities and consumer staples, have taken part in the equity market recovery, but to a lesser degree.
Now investors ask: What could change? What could support a sustained rotation?
Since March, and notwithstanding the wobbles in mega-cap US stocks in September, investors did well with a barbell strategy of growth and cyclical stocks. The cyclicals vs defensives trade is GDP sensitive, and our forecast for above-trend growth leads us to own cyclicality in our portfolios through exposure to European and emerging market equities. We see a higher bar for a rotation into value stocks: higher US government bond yields, which help value stocks via growth expectations, and higher net interest margins earned by banks.
Our equity colleagues think that much of the selling pressure for value stocks may be behind us. While this could be the case, we believe that evidence of a sustained path to higher interest rates and growing confidence in the economic growth outlook will be needed to prompt a positive rotation back into value. Still, the wide performance gap between growth and value styles could start to converge if tech stocks begin to struggle amid stricter regulation.
As the tech sector accounts for more than a quarter of the S&P 500, this raises one important question: Can the US beat non-US equities in the next cycle as it did in the last? It’s hard to identify a catalyst for when value might start to catch up to growth. But we believe diversification across equity regions gives us valuable exposure to the global recovery and helps avoid being caught on the wrong side of a rotation towards value.
In sum, we continue to take a diversified, pro-risk position in our portfolios but recognise that ongoing policy support likely means rates remain low for some time. So, while many investors are indeed alert to the wide gap between growth and value stocks, those looking for it to begin to close may also need a little patience.
John Bilton is head of global multi-asset strategy at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.