After a number of false starts, could it be that the much heralded ‘great rotation’ from bonds to equities has finally arrived? Trump’s victory in the US presidential election has accelerated a trend that began in July soon after the Brexit vote in the UK, with bond yields rising, the dollar strengthening, developed market equities rising, emerging market equities falling (only post-Trump) and cyclical stocks outperforming defensives. Post the US election, bonds suffered their sharpest correction since the 2013 ‘taper tantrum’, as the promise of decreased regulation, tax reforms, expansionary fiscal policy and an easier policy path through Congress, accelerated the move to equities.
With the rotation, market leadership has changed from quality to value, which itself has outperformed growth by 11% in the past three months. After years of outperformance, the safe, stable, defensive, ‘quality’ stocks were trading at high multiples with many sectors overcrowded and loaded with momentum risk. As our colleagues on the Episode blog recently commented “(…) we have arrived at a pivotal and potentially critical moment (…) .the strategies that have been successful for the last decade are now priced to struggle.”
Years of weak or deteriorating growth and inflation expectations across the globe were responsible for the huge premiums that the market had ended up placing on the pricing power and earnings stability of quality stocks. Expectation of rising inflation has acted as a catalyst for the rotation. Even so, the sharp rotation into value from an historical perspective is still very mild as the following chart illustrates.
At a sector level, the rotation has been out of defensives and into cyclicals, with the rising risk appetite benefitting higher beta stocks. There has been a significant shift into financials and out of the so-called bond proxies (staples, utilities, REITs and telecoms). Healthcare is the rare outperformer amongst the defensives reflecting the belief that a Trump administration is less likely to try to control US drug prices than a Clinton administration. (See our recent blog on healthcare).
The rotation between sectors and industries has been dramatic and volatility is likely to remain elevated in the short term, with rising rates continuing to fuel the bond-equity rotation. Even after the recent bond sell-off, equity valuations are still relatively attractive versus bonds. Additionally, the Trump administration is expected to push for fiscally expansionary policies and deregulation that should support cyclical expansion.
After two years of stagnation, a recovery in earnings will be key to the sustainability of the rotation. Earnings have been improving since Q1 2016 with results from the most recent reporting season for Q3 confirming a number of supportive factors including the bottoming in oil/commodities prices, the prospect of rising rates and improving growth forecasts.
Rising bond yields and a stronger dollar have been the two main drivers of the rotation since the US election. Going forward, from a sector perspective, financials should continue to do well as valuations are cheap and the sector is a beneficiary of further increases in bond yields. Financials also act as a hedge against rising yields and inflation. On the flipside, consumer staples are negatively correlated to bond yields, expensive and had a disappointing earnings season with many companies reporting a slowdown in growth. The sector is therefore vulnerable to further rises in yields. We could also see a change in investors’ search for yield as traditional yield stocks have fallen sharply as bond yields have risen. Previously, investors crowded into bond proxies that paid a high dividend yield; now, the key will be to find companies that are consistently growing their dividends.
Regionally, it’s the stronger dollar that’s proving to be more influential. Emerging market assets are suffering and further moves higher in the dollar could continue to hurt EM stocks. UK equities though have so far benefitted from a stronger dollar/weaker sterling, particularly large-cap stocks where more than 70% of revenues are earned overseas. However, further sterling weakness from here could see a rise in imported inflation that would impact the consumer. A stronger dollar/weaker yen has also helped Japanese equities as a weaker yen is a strong positive for Japanese earnings. Like Japan, the relative performance of eurozone equities was positively correlated to the dollar historically. However, it appears the region’s recent underperformance reflects investor concerns over the upcoming Italian referendum, as well as the uncertainty over next year’s French presidential elections.
The rotation from bonds to equities now looks to be firmly established, but it’s unlikely to be a smooth path in 2017. Markets will need to navigate an increasingly populist political backdrop and the combined ‘known unknown’ policy implications of Brexit and President Trump.