The odd couple of 2026: cyclicals and defensives

In this article, Russ Koesterich notes the year-to-date strength of both cyclical and defensive stocks, a pairing that seems too strange to last.

Key takeaways

• Investors are rotating away from tech and into cyclical and defensive sectors like energy, materials, industrials, staples and utilities – all of which are outperforming their high-flying tech peers year-to-date.
• The knock-on effect of this trade can also be seen among style factors, with value easily outperforming both growth and quality over the same time period. Interestingly, earnings momentum for tech stocks in particular remains largely unchanged.
• While current economic data supports staying invested in cyclicals, Russ recommends keeping an eye on these indicators, specifically labor market trends.

Those of us over 40 or 50 can probably still sing, at least in our heads, some of the songs from Sesame Street. One Sesame Street jingle that describes this year’s financial markets: “One of these things is not like the other, one of these things doesn’t belong’’. That is an apt description of year-to-date performance. After +3 years of tech dominance, markets are betting on a strange combination of cyclical and defensive stocks. One of these bets is probably wrong.

Year-to-date the best performing global sectors are mostly traditional cyclicals, such as energy, materials, and industrials (see Chart 1). To the extent fiscal stimulus and the impact of previous rate cuts translates into a strong economy, this makes sense. However, in addition to cyclical sectors, many traditional defensive ones, notably staples and utilities, are also outperforming. This part is harder to explain.

The odd pairing of riskier cyclicals and safer defensives also extends to style performance. Value is by far the best performing sector year-to-date, easily beating both growth and quality. A value rally is consistent with an optimistic economic narrative, as stronger growth results in operating leverage for non-growth companies. What is harder to reconcile is that low volatility, a strategy that generally works best in recessions, is also doing relatively well. That is not what you’d expect in an environment in which investors keep raising their economic expectations.

It's not earnings

Adding to the puzzle, relative performance does not appear particularly tied to changes in earnings expectations. Technology companies continue to enjoy the fastest earnings momentum. While many of the outperforming sectors, notably industrials, are experiencing negative changes to their 12-month earnings estimates.

What is going on? The simplest explanation is a swift rotation out of technology and AI related trades. Except for parts of the semiconductor industry, most of technology is underperforming, with software down more than -20% year-to-date.

With investors still in a buoyant mood, the money must go somewhere. Given the huge weight of technology stocks, roughly 33% of the S&P 500, the money coming out of tech and AI related names can fund a lot of buying in smaller companies and less dominant industries.

Jobs Data is probably the key

Going forward, how should investors think about this odd couple? My view is that the preponderance of evidence suggests sticking with the cyclical trade. The January non-farm payroll report was solid, manufacturing surveys are accelerating, economic surprise indices are at the best level in more than two years and earnings momentum favors select cyclical companies, notably materials, financials and semis. Should the labor market stumble, everything would arguably change as a weaker economy would undermine the appeal of cyclicals. But absent evidence of a sharp slowdown in labor markets, the recent pairing of highly cyclical and very defensive companies looks too strange to last.