Equity markets were relatively flat throughout June, in contrast with the drama of recent months, yet there was a noticeable rotation across sectors which has carried on into the early part of July. This rotation has seen sectors such as telecommunications, pharmaceuticals and utilities outperform at the expense of technology and consumer discretionary. In our view, there are two potential explanations for this mini-rotation:
Chart 1: Selected sector performance
Past performance is not an indicator of future performance and current or future trends. Indices cannot be purchased directly.
Some justification for the first explanation may be found in suggestions that sector (or perhaps stock) dispersion has gone too far in the short term – see below chart. This would suggest either the presence of exceptional value in some parts of the market that have previously lagged (telecoms, utilities, pharmaceuticals) or a lack of value in parts of the market that have done very well (technology, consumer discretionary).
Chart 2: European value vs growth is the most oversold since the 1990s
However, we struggle with such top-down arguments; the dividing line between growth and value is difficult to ascertain as it moves around over time: should the pharmaceutical sector now be considered a value sector as it has underperformed for so long? Or has the sector simply de-rated due to the significant challenges facing many of the companies (generic and bio-similar competition, significant pricing pressure from purchase groups, the need to reinvent/replace very large earnings streams)? Similarly, telecommunications has been impacted by persistent revenue deflation combined with harsh and excessive regulation and high capex requirements. Moreover, what are growth and value anyway other than opposite sides of the same coin? Furthermore, should pharmaceutical, telecom and utility stocks outperform or underperform when interest rate expectations are rising as implied by Morgan Stanley? That is not to say there are not individual stocks in these sectors that are attractive, but we believe top-down arguments are often too simplistic and do not work unless there is a change in the underlying fundamentals.
The relative earnings revision charts for telecommunications, utilities and pharmaceuticals – as sectors – remain unexciting with revision trends either below 50 (median) or only slightly above 50; should a more positive picture emerge for utilities and telecommunications this might indicate that certain stocks within these sectors are interesting.
Chart 3: Telecommunications estimates momentum - EPS
The performance of past values and returns is not indicative of their current or future development.
Chart 4: Utilities estimates momentum - EPS
Chart 5: Pharmaceuticals estimates momentum - EPS
We do recognise that sometimes share prices can get ahead of themselves and in our own activity we have been trimming technology and consumer discretionary stocks in the small number of cases where we think prices have run too hard and too fast. But our experience is that such rotations tend to fizzle out quite quickly unless there is a change in the underlying fundamentals and we really cannot see any such change at the current time.
We believe a market rotation based on a change in economic fundamentals is something to consider more seriously (as would be a change in economic direction or a downturn in the relative pattern of earnings revisions). In this context, certain sectors – more likely certain stocks – might look more attractive and others less attractive. To be crystal clear, although we do not select stocks and build portfolios based on a ‘top-down’ view, the prevailing and likely future economic conditions do influence our earnings and cash flow forecasts and, combined with our valuation work, influence our stock selection. Here again we see little to change our view; the following commentary from Mike Biggs in GAM’s Emerging Market Fixed Income Team encapsulates this:
“Based on macro fundamentals, we believe the outlook for risky assets remains good. At the end of 2017 and into 2018 the Economic Surprise index moved positive. It then subsequently deteriorated into negative territory, largely driven by the euro area with added headwinds from the volatility spike in February, the Italian elections and ongoing trade war concerns. Meanwhile PMIs got to extremely high levels, before retrenching in the first quarter, and we have seen a renewed uptick in the latest month’s numbers. The credit impulse has been positive in Europe. This is normally associated with above-trend growth, but there is nothing to explain why PMI readings were quite so high. The lending numbers out of Europe are still strong. May’s figure is consistent with a PMI of 54 to 55, which would indicate 1.5% to 2% growth; growth in Europe is above trend and positive for risky assets”.
Chart 6 shows the credit impulse for the euro area while Chart 7 shows the Citi Economic Surprise Index for the eurozone. Note that these high frequency metrics are ‘second derivative’ indicators, and that while it is often the case that activity/growth is positive while these indicators are trending down (as was the case over the past few months), the converse can also be the case. Both indicators are currently pointing upwards, having pointed downwards in prior months, seemingly suggesting acceleration in economic activity and that the next surprise to consensus expectations may be to the upside.
Chart 6: Credit impulse for the Euro area
Chart 7: Economic Surprise Index for the Eurozone
The key point we want to make is that we struggle to see evidence for a significant change in economic fundamentals either from the indicators above or what we are hearing from our investee companies. We think some commentators have extrapolated what was a slowdown in the rate of growth from well above trend levels to ‘decent’ growth levels and have drawn the wrong conclusions. Considering both potential explanations for a market rotation we consider neither to be convincing and consequently do not believe that the recent market rotation will be maintained and that stock specific fundamentals will remain key. We find the economic damage from an escalating trade war more difficult to read given the unpredictable nature of US policymaking; we believe the tariffs imposed thus far are unlikely to have a major impact, but a continuation and escalation could well have a bigger first and second round impact through reductions in business confidence and reduced investment. We acknowledge this as a risk and something we will have to monitor and consider carefully going forward.
Chart 8: Selected sector performance – 5 years