In a week ending with ‘Friday the 13th’, investors were not spooked, and continued to bid up prices of global risk assets. Market participants took heart from the US election outcome and declining odds that the result will be effectively contested by President Trump. Surprisingly, investors also looked past worrying record rates of US Covid-19 infections and hospitalizations, accompanied by a climbing death toll.
Recent global equity market performance has shifted. Rotation into energy, small capitalization, value and cyclical stocks was plainly evident last week. Erstwhile stalwarts, such as growth, information technology or momentum stocks are beginning to lag. This would be a big deal if it continues because value has underperformed growth for more than a decade.
So, does recent market performance herald the start of a full-fledged rotation from growth to value stocks?
Our take is, yes, value and cyclicals will lead markets higher. But with an important caveat – not yet.
It is likely that fans of rotation will get a boost this coming week as various Fed and ECB speakers provide reassurance that monetary policies will remain highly accommodative and flexible. However, it should be expected that US retail sales and industrial production will depict a mixed picture about the health of consumers and producers. And incoming economic indicators will be viewed as backward-looking, given the backdrop of rising pandemic risk as colder weather envelopes the northern hemisphere.
Importantly, the coming few weeks also hold out the promise that other biotech and pharma companies will release encouraging vaccination test results, backing up last week’s promising trial studies from Pfizer and BioNTech.
In short, the near-term economic, public policy and pandemic news flow is likely to be uneven, producing fits and starts in global markets. This won’t enable a sustainable rotation into riskier stocks – for that to happen, investors require an uninterrupted period of positive developments.
History also suggests that rotation into value and cyclical shares necessitates more than just attractive absolute or relative valuations. The crucial factor is earnings acceleration. Value and cyclicals only tend to sustain outperformance when their relative earnings growth picks up compared to that of the broader market.
In that regard, concerns about tighter social distancing regulations in the coming months are likely to raise doubts about the ability of financials or industrials to boost profits soon. Pandemic control remains critical to durable economic and earnings recoveries.
Dividend yielding stocks – often found in the value universe – may also struggle to regain favor among investors, given uncertainties about sustainable payouts. The energy sector, which was last week’s top performer, will come under greater scrutiny due to the Biden Administration’s carbon emission reduction priorities.
Concerns about growth and demand in the US and Western Europe will act as a brake on the fortunes of more cyclical emerging economies, including those heavily reliant on commodities and basic materials. For now, countries in North Asia, including China, South Korea and Taiwan appear better positioned to weather pandemic-related jitters in global capital markets.
Still, the picture is brightening for more cyclically sensitive sectors and styles. Modest US fiscal stimulus, arguably postponed until early 2021, implies an even more accommodative Fed stance. The result is likely to be a weaker US dollar, which typically supports raw materials prices and emerging markets. Despite surging infection rates, state and local governments have learned from experience that social distancing, mask mandates and increased testing are preferable to full-scale lockdowns. Firms are able to cope with remote and flexible work routines. Accordingly, the economic and earnings hits related to pandemic control should be less onerous than earlier this year. And critically, the prospects for the successful rollout of a vaccine next year will provide key support to markets.
Overall, the conclusion is that while sector rotation is arriving, patience is warranted.
Market performance will probably be uneven and inconclusive over the remainder of 2020. Investors will be reluctant to shun what has been working – e.g. large capitalization information technology stocks – so long as infections are rising at high levels. For now, it might be wise to barbell growth and quality with value and cyclicals, shunning momentum (which will struggle as markets oscillate). Furthermore, US dollar weakness is an opportunity in its own right and will also support emerging equities and currencies.
Rotation in markets is the next big opportunity. Value has a lot of room to make up for a decade of underperformance. But sometimes it pays to be patient. Now is one of those times.