Sector allocation during the business cycle using supply-side PMI® data

A business cycle approach to equity sector allocation is rooted in the hypothesis that certain sectors will perform differently during certain phases of the economic cycle. Therefore, investors can optimize their portfolios by correctly timing changes to their exposure to these sectors.

The challenge is how best to determine business cycle phases when there are multiple sources of macroeconomic information to choose from. Moreover, historic data revisions, lagging availability, mismatched release timings and conflicting signals add further layers of complexity to building a timely and comprehensive business cycle indicator. For a business cycle approach to sector allocation, timeliness is critical and tilting exposure too early or too late could have adverse consequences on portfolio performance.

 A solution lies in PMI® survey data by S&P Global, available for more than 40 countries and 34 different sectors, covering approximately 90% of global GDP. The data are released at the start of every month, unrevised, and cover critical business barometers such as output, demand, employment, prices and inventories. This provides users with a powerful and comprehensive dataset that enables a multi-dimensional assessment of prevailing economic conditions in near real time. The suitability of PMI data for business cycle analysis is clear and in this paper, we detail how it can be leveraged to analyze the business cycle and build systematic investment allocation frameworks.

We determine the business cycle phase through the lens of the supply side of the economy, rather than the demand side. The supply side of the economy tends to react to changes in demand (e.g. businesses hire and invest more during an expansion, they raise production when orders are rising), but with the proliferation of tariff policy and trade barriers, conflicts and wars, rising climate-related supply risks, as well as the emergence of new disruptive technologies, supply conditions, and expectations around the supply side, have determined demand, prices and other economic behaviors in recent years. For example, we’ve seen inventory management strategies change from “just-in- time” to “just-in-case” since the COVID-19 pandemic. This has lifted the risk of the so-called bullwhip1 effect occurring more frequently, amplifying the cyclicality of the supply side of the economy to the point where it can shift the business cycle into a different phase. The global supply-chain crisis post-pandemic, Russia’s full-scale invasion of Ukraine, the Red Sea crisis, as well as the war in the Middle East, all serve as recent examples of how supply-related disruptions and fragilities can be catalysts for changes in the real economy.

In this paper, we illustrate how a hypothetical investor can tactically tilt sector exposure as the supply side of the economy moves through different cycle phases.