A rotation in equity markets starts to emerge
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
“Ready for take-off” was the instant market judgment for a beleaguered airline industry on news of a breakthrough in the development of a Covid-19 vaccine.
A 15 per cent plus surge in the US shares of United Airlines, Delta Air Lines and American Airlines on Monday was bettered by British Airways parent International Airlines Group jumping 25 per cent. Ruling the sector roost for one-day price surges was Rolls-Royce, with the UK jet engine maker up 44 per cent.
Airlines along with energy, finance, real estate, retail and hospitality are among the sectors hit hardest by Covid-19. The arrival of good news duly triggered a classic surge in their value from very cheap levels, but this week’s “vaccine pop” still leaves them trading well down on the year.
Widespread deployment of a vaccine will take time and not likely reach critical mass until mid-2021. In the interim, many countries are experiencing a rising number of infections and social restrictions heading into the northern hemisphere winter.
In market terms, near-term anxiety and additional pressure on economic activity over the coming months will compete with the natural tendency among investors to look ahead.
That will manifest itself in a debate over whether the first tangible sign of life beyond the pandemic represents a catalyst that triggers a temporary or sustained shift in global equity leadership across sectors and regions.
For investors, successful equity performance has consisted for a long time of owning popular technology names that offer growth potential and cash flow generation far ahead of the rest of the share market.
Given the dominance of tech within the US market, Wall Street has duly run up the scoreboard compared with other parts of the world where companies and sectors more exposed to the economic cycle dominate equity benchmarks.
Long-term investors have been vocal that such a sharp divergence between share market sectors and regions represented a spring waiting to snap back. That was certainly the case when news of the vaccine broke on Monday.
From here, the merits of a sustainable rotation of investor holdings of stocks and sectors depends considerably on the extent of the anticipated economic recovery next year.
Yes, a rough few months loom, but arguably 2021 looks brighter when you combine the promise of Covid-19 vaccines with the existing stimulus from governments and central banks. A vaccine on the way will help companies plan ahead, leading to greater business investment across sectors and the economy.
Another tailwind for cyclical stocks and sectors is that, after such a grim year, the 2021 earnings of these companies should look better by comparison. In contrast, big tech stocks have a higher bar in terms of surpassing earnings expectations after this year’s gains.
Rising long-dated government bond yields from stronger economic fundamentals will also weaken the appeal of paying a premium for growth companies and help sustain a rotation towards other areas of the equity market.
“The growth names that have carried markets to this point remain attractive on a three-year view, but now are likely to take a back seat as near-term year-over-year comparisons will be more difficult for them,” argued Stephen Auth, chief investment officer for equities at Federated Hermes.
In global terms, an economic recovery should boost the relative performance of equity markets in Europe, Japan and the UK, which are far more reliant on the performance of cyclical companies. The FTSE All World equity index, excluding the S&P 500, is back in positive territory for the year and has rallied nearly 11 per cent so far this month thanks to gains in those markets.
The UK’s FTSE 100 represents a “global cyclical bellwether”, given that almost three-quarters of the total revenue of the benchmark’s constituents is international, according to research firm TS Lombard. “With the vaccine signalling rotation into cyclicals, the UK market is set for outperformance,” it said.
However, a rotation in equity markets as the pandemic fades is likely to represent a tactical, rather than a secular, shift within equities. A more sustained move requires more growth and more inflationary pressure. Small-cap and cyclical stocks need greater pricing power that helps boost their earnings.
That may come in time, but investors also note that over a longer period, many tech companies will retain superior earnings growth prospects. And while tech companies are sometimes disruptive forces, they also can be considered defensive investments. Strong cash flow and low debt is a hallmark of quality and this appeals during periods of market turmoil.
“Tech has such a superior growth rate, and it also has defensive qualities within a portfolio that provides diversification benefits,” observed Jim Paulsen, chief investment strategist at the Leuthold Group. “Tech will underperform, it will not crater. Over a 12 to 36 month horizon, tech looks good to me.”
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