Sector Rotation
The cyclical movement of investment flows between different equity sectors as economic conditions change — typically following a predictable pattern tied to the economic cycle, credit conditions, and interest rate environment.
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What Is Sector Rotation?
Sector rotation describes the tendency of investors to shift allocations between industry sectors in response to changes in economic conditions, interest rates, and the business cycle. Rather than timing the market (being all-in or all-out), investors adjust sector weights based on where they believe the economy is in its cycle.
The Economic Cycle and Sector Performance
The classic sector rotation framework maps the business cycle to sector performance:
Early expansion (recovery from recession):
- Outperformers: Consumer Discretionary, Financials, Technology, Industrials
- Logic: Rate cuts boost borrowing; consumer confidence rebounds; credit expands
Mid-cycle expansion:
- Outperformers: Technology, Communication Services, Industrials
- Logic: Corporate capex cycle; tech earnings growth
Late cycle / overheating:
- Outperformers: Energy, Materials, Healthcare
- Logic: Commodities benefit from inflation; healthcare is defensive; energy demand peaks late
- Underperformers: Consumer Discretionary (margins squeezed), Real Estate (rising rates)
Recession:
- Outperformers: Utilities, Consumer Staples, Healthcare
- Logic: Defensive, non-cyclical earnings; dividend yield attractive vs zero interest rates
- Underperformers: Financials, Industrials, Consumer Discretionary
Interest Rate Sensitivity by Sector
Sectors with long-duration earnings (high P/E, low current yield) are most rate-sensitive:
- Rate sensitive (underperform when rates rise): Technology (high P/E), Real Estate (leveraged), Utilities (bond proxies)
- Rate beneficiaries: Financials (net interest margin expands), Energy and Materials (real assets)
2022 as a Textbook Example
2022's sharp rate hikes caused a near-textbook defensive rotation:
- Technology fell -33% (high P/E, long duration)
- Energy rose +65% (commodity price spike + real asset)
- Consumer Staples fell only -3% (defensive)
- Utilities fell -5% (defensive but rate-sensitive)
Macro Signals to Watch
- Yield curve shape: Flattening → favour defensives; steepening → favour cyclicals
- PMI direction: Rising PMI → cyclicals; falling → defensives
- Credit spread direction: Widening → defensives; tightening → cyclicals
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