The absence of compelling alternatives has been a key driver of equity performance in recent months. As yields have plunged, the appeal of bonds has waned. The chief beneficiaries in global equity markets have been companies able to deliver solid earnings, cash flows and dividends, or those with compelling future growth stories. Yet that has become a tired story, reflected in stretched valuations and strong consensus positioning. However investors do not yet see an alternative. They do not appear ready to move into cyclical, value, small capitalisation or financial stocks, given concerns about future growth as expressed in flat or inverted yield curves.
Episodes of market rotation have accordingly been brief and tentative, and have dissipated fairly quickly. But if the global equity market is to perform well in the second half of 2019, following a very strong showing in the first six months of this year, rotation will be necessary.
Rotation is typically driven by a belief that earnings have bottomed in lagging sectors, which today comprises mainly cyclicals or value stocks, including industrials, parts of consumer discretionary, commodities & materials and financials. It also includes emerging markets and Europe. Yet the basis for an earnings inflection point in those sectors and regions is not obvious; global growth, manufacturing and trade continue to print weak numbers.
Without rotation, the broad equity market will likely struggle to advance. Much anticipated support from central banks is already reflected in market pricing. A more promising development would be for economic growth to stabilise following the recent reduction in trade tensions and as a result of the board easing of financial conditions that has taken place over the past few months. Should activity in manufacturing and trade show signs of stabilisation, heralding an inflexion point, lagging sectors could lead global equities higher. Without that outcome, global equities are more likely to stall.
In an environment of lower returns, accompanied by recurring volatility, selectivity becomes more important for portfolio management. Performance will depend as much on loss avoidance as on generating attractive returns where they are on offer. Appropriate diversification, marrying different sources of return within portfolios to enhance stability of portfolio performance, becomes paramount. That means taking selective directional risk in equities and fixed income, alongside non-directional risk achieved via diversified relative value and carry positions. Target return and alternative risk premium approaches must now shoulder a greater responsibility for providing diversification, a theme that is likely to extend over the remainder of this year and into 2020.