We take a look at what has caused the vicious rotation in developed equity markets this year and how we expect it to play out.
"A rising tide lifts all boats"
John F Kennedy
Sadly not in the case of equity markets. Developed world stocks are bobbing around record highs, but just as an ocean rip current gives the dangerous illusion of calmness on the surface, such apparent tranquillity masks hidden turmoil. Since mid-March a vicious rotation has gripped markets on both sides of the Atlantic, causing investors to swim hurriedly to safety.
Investors last year were swept up in the anticipation of a burgeoning developed world recovery. This wave of positive sentiment saw them well rewarded for owning companies positioned for growth and those exposed to consumer discretionary spending. Domestically focused businesses were also in vogue, while mid-cap companies outperformed their larger peers.
But the tide has now gone out on many of these stocks. This year there has been an aggressive rotation, out of growth and momentum shares into value stocks. Momentum refers to the tendency of rising shares to keep going up – but they have not lived up to the name. Former market leaders in the US such as biotechnology and internet stocks have fallen over 25% from early-year highs. In Europe the reversal has been so large that the highest-momentum stocks are now cheaper (based on price-to-book value) than low-momentum stocks for only the third time in 25 years. The reversal in sentiment can be seen in the following chart:
High price momentum reversing
Many once-surging small stocks also began to plunge as investors fled to safer, large-cap stocks paying bigger dividends:
Small-cap Growth reversing vs large Value
Source: Kepler Cheuvreux
Finally, stocks with emerging market (EM) exposure have also begun to swell recently, amid a period of EM outperformance more generally:
EM exposed stocks performance reversal
The perfect storm
The choppy conditions in equity markets have been caused by a perfect storm of full valuations, overcrowded positioning and ominous bond market behaviour.
Indeed, developed market equities were beginning to look fully valued, particularly in the US, as we highlighted in our latest White Paper: Dark Cloud, Silver Lining. This was certainly true of biotech and internet firms. Online social network Twitter, for example, surged 75% on its market debut, valuing the company at $30bn despite the fact it doesn’t make a profit.
With a growing sense of unease about valuations in such high-flying concept stocks, there has been profit-taking in many of 2013’s best performing stocks and sectors, initially in the US and later in Europe and the UK. This helps explain an element of the rotation –winners have been sold and underperformers bought. We have also seen a lot of new equity issuance in recent months, which may have exacerbated this trend, as investors used profits on existing holdings as a source of funding.
Additionally, in a classic sign of a maturing investment cycle, European positioning had become very concentrated. A lot of new money cascaded into the region last year to play a European recovery. Accordingly, these investors shunned defensive stalwarts in the Utilities and Consumer Staples sectors in favour of smaller, growth orientated companies in sectors like Consumer Discretionary and Financials. This left many positions increasingly overcrowded, meaning a trickle of selling rapidly turned into a flood as investors rushed to protect their profits.
These elements of the storm suggest that the rotation is merely a case of temporary repositioning and derisking, a necessary period of consolidation following last year’s impressive rally. However, some commentators are pointing to darker clouds on the horizon.
One such omen is the recent sharp fall in US bond yields. Because they move inversely to bond prices, yields often fall when investors expect a weaker economic outlook and buy “safer” investments such as bonds. As can be seen from the chart below, the 10-year yield recently dropped to its lowest level since July 2013. This trend has surprised many investors who expected a robust US recovery, combined with the steady reduction in the Federal Reserve’s bond-buying, to cause yields to rise.
US bond yields falling
Source: TT International
Similarly, yields in peripheral Europe have been falling, as have their “spreads” over German bunds, a measure of the premium investors require to hold riskier peripheral bonds.
Periphery spreads becoming more compressed
Source: JP Morgan
Once welcomed as a sign of growing stability, these tighter spreads are now seen as an ominous message in a bottle warning of an imminent deflation scare. This argument has some merit. Europe does seem to be entering a twilight zone of ultra-low inflation and is probably only one major shock away from outright deflation. In fact, stripping out the effects of one-off austerity driven tax hikes, 23 out of 28 countries in the European Union, including Italy, France, Spain and the Netherlands have been in outright deflation since mid-2013.
Navigating through the storm
So will the storm grow into a Category 5 or hit land and lose power? We expect the turmoil to be temporary for a number of reasons.
Firstly, it’s normal for crowded positions to be flushed out regularly. As more and more people pile in to popular trades, each new buyer is less sure of the idea than the last. Once prices start to move against them, they prove weak owners, not really believing the story. As these crowds try to escape, prices move a long way quickly. Once the weaker owners are cleared out, however, the stock’s compelling fundamentals will shine through and the story can start over again.
Furthermore, fears over the bearish messages being conveyed by lower bond yields are likely to prove exaggerated. Economic data continues to signal a gentle cyclical recovery in the developed world. Though backward-looking data have disappointed, more timely and forward-looking numbers have been encouraging, particularly US jobs and European business activity.
That’s not to say the coming months will be plain sailing. The rotation has wounded countless investors, yet liquidity has dried up, meaning many are still waiting for their chance to exit painful positions, which could prolong the turbulence. Other potential risks include economic data deteriorating, earnings growth failing to materialise and the European Central Bank not acting in June to combat the spectre of deflation.
Ultimately however, we continue to see a gradually improving global economic environment. Thus, while painful in the short run, such rapid undulations in investor sentiment from greed to fear will undoubtedly throw up lucrative opportunities that we look forward to exploiting.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).