Defensive Rotation in 2025: A Historical Lens on Risk-Off Behavior

The market's 2025 pivot was a textbook flight to safety. As fears of a prolonged tariff war and weakening consumer sentiment took hold, investors sharply rotated out of high-risk cyclical sectors and into traditional defensive havens. The performance divergence was stark: while the S&P 500 benchmark SPY was down -1.6% year-to-date, the healthcare (XLV), consumer staples (XLP), and utilities (XLU) sectors were up 7.7%, 4.4%, and 3.1% respectively. This wasn't a minor shift; it was a decisive move away from the tech and consumer discretionary stocks that had powered the market for years.

The scale of the economic shock that triggered this behavior was historic. The April 2nd tariff announcement alone raised the effective US tariff rate by 11.5 percentage points, the highest single increase since 1909. This policy action, and the broader 2025 tariff regime, created a tangible threat to corporate earnings and consumer wallets, directly fueling the risk-off sentiment.

Yet a key disconnect emerged. Despite the defensive rally, the underlying earnings story pointed the other way. Cyclicals are projected to outpace defensives through 2027, with earnings growth models showing stronger acceleration in those sectors. This sets up the central question of sustainability: can a rotation driven by fear and uncertainty hold when the fundamental growth outlook favors the very sectors being sold off?

Historical Precedents: What Past Rotations Tell Us

The current defensive rotation echoes past episodes of risk-off behavior, but history suggests its endurance hinges on the persistence of underlying economic distress. Looking back, we see a consistent pattern: defensive sectors rally as a safe haven, but their outperformance typically fades when the source of fear recedes.

The 2008 financial crisis offers a clear template. As the recession deepened, sectors like healthcare and staples provided a crucial buffer, with their excess returns benefiting during periods of slowing growth. Their outperformance was sustained for as long as the economic pain lasted. The rotation back to cyclical stocks began only when signs of recovery emerged and earnings for those sectors started to stabilize. This underscores a key point: defensive gains are often a lagging indicator of economic weakness, not a standalone driver of returns.

A more recent example is the 2011 debt ceiling standoff. Defensive stocks acted as a temporary haven during that period of political volatility. Yet the rotation was short-lived. As the immediate crisis passed and market volatility eased, the rotation reversed. This highlights the limited staying power of defensive moves driven by temporary policy uncertainty rather than a fundamental shift in the economic cycle.

The 2018 trade war escalation provides a third, instructive parallel. Defensive sectors like staples saw a rotation as tariffs threatened consumer spending. However, their gains were muted compared to the broader market's resilience. This episode shows that even when defensive sectors benefit from a specific fear, the broader market can absorb the shock, limiting the long-term advantage for the havens. The rotation was a tactical pause, not a strategic reallocation.

The common thread across these episodes is that defensive outperformance is a function of duration. It lasts as long as the risk-be it recession, political crisis, or trade war-remains a credible threat to earnings. When that threat diminishes, the rotation often unwinds. Given the current setup, where the fundamental earnings growth model still favors cyclicals, the historical record suggests the defensive rally may be more of a tactical pause than a permanent shift.

Earnings vs. Sentiment: The Current Disconnect

The market's defensive positioning now sits in stark contrast to the fundamental drivers that powered the 2025 rally. The gains were overwhelmingly concentrated in a few high-flying sectors. Nearly 60% of the market's total 17.4% gains in 2025 came from the technology and communication-services sectors. Within that, the contributions from Nvidia and Alphabet each added over 2 percentage points to the S&P 500. This was a classic cyclical-led expansion, driven by the AI boom and software infrastructure, not by defensive stability.

Historically, defensive sectors like healthcare and staples have their niche. They tend to benefit from rising inflation and economic uncertainty, acting as a buffer during downturns. Yet their long-term outperformance is not guaranteed when the broader earnings growth story favors cyclicals. The 2008 crisis saw defensive excess returns during slowing growth, but the rotation back to cyclical stocks began only when recovery signs emerged. The current setup is different: the fundamental earnings model still projects cyclicals to outpace defensives through 2027. This suggests the defensive rally may be a tactical pause, not a strategic shift.

The weak consumer sentiment provides a direct link to this tension. The Index of Consumer Sentiment is at 52.9, down significantly from a year ago. This typically pressures consumer discretionary and staples, the very sectors now seen as havens. Yet their recent performance has been poor, with the consumer defensive sector gaining just 1.1% in 2025. This disconnect highlights the market's focus on future earnings potential over present sentiment. Investors are betting that the AI-driven growth in tech and communication services will eventually lift all boats, even as current consumer weakness weighs on traditional defensive names.

The bottom line is a classic divergence between price and value. The market's price action in 2025 was a cyclical story, while the recent rotation is a defensive reaction to fear. History shows such rotations often fade when the underlying economic threat recedes. Given the persistent earnings growth forecast for cyclicals, the current defensive positioning looks vulnerable to a reversal if sentiment improves or if the tariff-driven uncertainty begins to lift.

Catalysts and Scenarios: What Could Reverse the Flow

The defensive rotation's endurance now depends on a handful of forward-looking events. The market is waiting for concrete data to resolve the tension between current sentiment and the longer-term earnings forecast. Three key catalysts will determine whether this pause becomes a permanent shift.

First, the upcoming earnings season is the immediate test. Guidance updates that confirm cyclical resilience-particularly in tech and communication services-could trigger a rotation back to those sectors. Conversely, downward revisions to defensive forecasts, as seen in utilities and food producers, would validate the current flight to safety. The current setup is a classic divergence: while the severe rotation has created opportunities in secular growth names, the market's price action still hinges on whether these companies can deliver on their elevated expectations.

Second, the long-term economic impact of tariffs will be a persistent drag. The Budget Lab models that all 2025 tariffs will permanently shrink the US economy by 0.4% to 0.6%, equivalent to a $100 to $180 billion annual loss. This projected GDP drag undermines the cyclical growth thesis that underpins the market's earlier rally. If this permanent damage materializes, it would pressure earnings across the board, potentially limiting the upside for cyclicals and prolonging the defensive bias. The initial shock to consumer prices, with a 1.3% short-run price level rise from the April announcement alone, already weighs on household budgets and could persist.

Finally, Federal Reserve policy signals will set the monetary tone. A delay in rate cuts, as suggested by strong economic indicators and sticky inflation, could pressure high-quality cyclicals that have benefited from easy money. The Fed's case for easing remains modest, with the central bank facing little pressure to cut. On the flip side, an actual rate cut would likely boost growth-sensitive sectors and provide a tailwind for the cyclicals that are projected to outperform. The market's current positioning leaves it vulnerable to a shift in the Fed's stance.

The watchlist is clear. Monitor earnings guidance for signs of cyclical strength or defensive weakness. Track the trajectory of consumer spending and inflation to gauge the real impact of tariffs. And listen for any shift in the Fed's communication about the timing of cuts. These are the levers that will decide if the defensive rotation is a tactical pause or the start of a new regime.