Does re-opening mean re-orienting equities?
Market sentiment has improved as economic restrictions are eased and policy makers continue to add incremental support. This is fueling a rally in cyclical sectors as markets discount a faster path to economic recovery and look for more attractive value segments in the equity market. History has shown that these sectoral shifts can be fleeting, but is this the start of a longer-term rotation within equities?
As economic activity data has bounced off of severely depressed levels, markets are reflecting this as a signal of a slightly faster return to normal and a shift towards more cyclically geared sectors. The sector composition of many equity markets has swayed both performance and valuation during the COVID crisis. The dominance of a handful of companies in the S&P 500 and defensive nature of the rally to date have left many questioning the elevated valuation of the index. The forward price-to-earnings ratio on the S&P 500 of 21.0x is some margin above its long-run average of 14.6x and only just below the high point set a few weeks ago. The relative valuations across sectors are further influencing the shift to the underperforming sectors.
The recovery from the COVID-19 crisis will be uneven across economies and sectors. As the timing of the spread of COVID-19 varied by country, so will its retreat. The Oxford Stringency Index from Oxford University tracks the policy responses from governments by using publicly available data on social distancing policies, school and office closures and restrictions on domestic and international travel, as well as other metrics. A reading of 100 implies the most strict containment and Exhibit 1 plots the current stringency index and move from the maximum level.
EXHIBIT 1: DISPERSION OF EASING IN VIRAL CONTAINMENT MEASURES
Notably, Korea and Italy tightened restrictions around the same time and are the countries now furthest along the easing path. We are cautious of comparing the experience of individual countries based on this data given the variety of policies implemented. However, a reasonable assumption may be that the countries doing better during containment perform better upon re-opening. This illustrates the divergent stages across countries and is a trend we expect to continue given it is still early stages.
While economies continue to ‘get back to work’ and the relative valuation argument for cyclical sectors remains, the durability of this rotation is influenced by the strength and path of the recovery. There is the risk that the headlines around progressive re-opening and the improvement in high-frequency data, such as google mobility data and restaurant bookings, still disguises a potentially more difficult return to normal for some sectors and an incomplete recovery.
How far will sentiment indicators recover? When it comes to key indices, such as the Purchasing Managers’ Index for manufacturing or services sectors, April was a record breaker for just how far and fast they can drop within one month. Understandably, the subsequent bounce has been welcomed as a sign of being past the worst and the start of an initial release of pent up demand. But even as the economic data improves, it is likely to remain at level which points towards an incomplete recovery as the continuation of social distancing policies hamper the recovery and pick-up in service-oriented demand. Especially if consumer demand is linked to the outlook for the labor market and potentially a long tail when it comes to a falling unemployment rate on the back of an incomplete recovery.
How high can bond yields go? Policy support has been crucial in stabilizing markets and the continued incremental fiscal and monetary support will undoubtedly feed into rising equity markets. Depressing bond yields improve the relative valuation of equities to bonds, as well as to historical comparisons by lowering the discount rate applied to future earnings. While this is positive for the overall market, historically it is higher bond yields and steeper yield curves that feature in a more persistent rotation towards more cyclical sectors.
The re-opening of countries around the world will not happen at the same speed. Some countries are easing restrictions faster than others and the sequence will influence allocation at the regional level. It will be a similar case for the cyclically orientated sectors which have underperformed in a defensive-led rally. There is little to immediately impede the positive risk sentiment and the continued release of many countries from the strict rules that brought a sudden stop to economic activity should continue to support risk sentiment. However, the durability of rotation is at risk until there is more clarity on just how robust the initial recovery will be. Furthermore, the evolution of viral risk to political risk should not be overlooked. In short, a focus on quality in corporate fundamentals is required no matter the sector.