Winners from the divergence

My table might help. It shows coefficients of annual changes in some FTSE sectors with respect to US and UK industrial production growth since January 1996. (I'm using industrial production as an indicator of general cyclical conditions: it tends to fall more than GDP in bad times and rise more in good.)

Insofar as the past is a guide to the future, losers from the UK-US divergence will be sectors sensitive to UK growth but not to US growth. Two that stand out here are miners and construction.

Construction stocks, on average, see annual returns of 3.6 percentage points below average whenever UK output growth is a percentage point below average. This is a lot at a time of low returns on equities generally.

This shouldn't be surprising: we've always thought of such stocks as being cyclical. What might be surprising is that mining stocks are also highly correlated with UK growth. This seems odd: miners are global and have only small exposure to the UK. I suspect that what’s going on here is a case of correlation not being causality. The slump in mining stocks in 2011-12 happened to coincide with the UK economy being weak relative to the US. This accident generated a positive correlation between mining returns and UK growth. This doesn’t mean mining stocks will lose from another UK slowdown.

The winners from the UK-US divergence should be those that are sensitive to US growth but not to the UK. Unsurprisingly, these include some globalised sectors such as oil companies, pharmaceuticals and banks.

The statistics tell us that telecoms also fall into this category, but I wouldn't rely upon this as a guide to the future. The strong correlation between these and US growth comes in large part from the late 90s when telecoms were growth stocks that benefited from the tech bubble. Now the sector has gone ex-growth that episode might not be a guide to the future.

There's another category: stocks that aren't sensitive to either UK or US growth. As you'd expect, these are defensives such as tobacco, beverages and food retailers.

You might find something odd about these numbers. They seem to contradict some widely-held views of which stocks are cyclical and which aren't. We think of support services and general retailers as being cyclical, but the statistics show that they aren't significantly correlated with UK output. And we don't think of general financials and IT hardware as cyclicals, but the numbers suggest they are.

Here's a theory about why this might be. To see it, remember that the correlations in my table are contemporaneous; they show the equity returns associated with output growth in the same period. If investors fully anticipated economic fluctuations, all the correlations would be zero. For a few sectors, however, investors do anticipate them - not so much by heeding economic forecasts perhaps as by using scuttlebutt: prices, remember, should embody the dispersed and fragmentary knowledge of all investors. This generates zero correlations. It's likely that this is the case for some "cyclical" sectors simply because if investors believe that the state of the economy matters for share prices, they’ll be especially alert to early warning signs about its health.

However, falling output doesn't hurt equities merely by depressing corporate earnings. It also depresses appetite for risk. This is especially bad for sectors which are most sensitive to investors' sentiment, such as financials and IT hardware.

All this suggests that if you believe the economic forecasts you should favour globalised stocks such as oils and pharmaceuticals and avoid construction stocks.

But of course, you might not believe the forecasts: they have often been wrong in the past. This leaves you two options. If you think they're wrong, you should do the opposite - back construction and dump oils. If you have no view, you should have a balanced portfolio in which defensives have a big role. But then, history tells us that this is usually the right thing to do.