The UK’s FTSE 100, the US’ Russell 2000 and Japan’s Topix are some of the indices that could go through a period of continued strong performance as the coronavirus vaccine rollout progress and bond yields continue to rise, according to Unigestion strategists.
Although there have been some high-profile examples of ‘vaccine nationalism’ as some countries seek to ensure adequate supplies for their own populations, the rollout of the coronavirus vaccine is progressing well – especially in places like the UK and the US.
But the expectation of stronger growth later this year as the global economy starts to unlock has prompted concerns that higher inflation could follow. These worries mainly manifested themselves in the bond market, with 10-year US Treasury yield climbing some 82 basis points since the start of the year to end last week at 1.73 per cent.
As the chart below shows, this has prompted some heavy losses for government bonds while global equities have dipped at times as investors questioned whether higher inflation would cause central banks to dial back on their stimulus programmes.
Performance of bonds and equities over 2021
Source: FE Analytics
At the same time, the global stock market has seen some sectors fare better than others.
Growth sectors that performed well in 2020, such as consumer staples and technology, have struggled this year as markets weigh up how the potential increases in interest rates would impact them.
On the other hand, the likes of energy, financials and industrials – which are more cyclical in nature and endured tough times last year – have posted strong year-to-date gains as investors eye stronger growth.
Performance of MSCI AC World industries over 2021
Source: FE Analytics
Salman Baig, multi-asset investment manager at Unigestion, said: “The knock-on effects of the rise in bonds yields pose significant risks and opportunities to investors. Importantly, they provide further support for the rotation in equity markets that came to the fore as vaccination programmes commenced. The prospect of economic normalisation bodes well for the bottom lines of firms that have struggled over the last year.
“Beyond this macro support, the cheaper valuations and least-favoured status of these equities provide fertile soil for a strong comeback. In this context, swiftly rising bond yields could transform an orderly rotation, where equity markets continue to rise while a rotation occurs under the surface, into a disorderly one, where the rotation rises to a tumult and the broader market is challenged.”
Unigestion believes investors will need to pay more attention to alpha in the current market environment, as beta is likely to be challenged by rising yields and correlation shifts.
Amid the firm’s expected backdrop of “a strong cyclical recovery producing upward inflation pressures”, it thinks there is a good opportunity to search for alpha among country indices.
Looking back over 2020, Baig noted that investors “unsurprisingly” bought growth stocks after the initial coronavirus shock as these companies offered a combination of resilient earnings, strong balance sheets and cash flows that benefited significantly from lower rates.
This had an impact on the performance of country indices, as these sent investors in the direction of those with large exposures to defensive sectors, such as consumer staples, communication services, healthcare and tech.
Cyclical-biased country indices, or those with a high allocation to areas like industrials, financials, energy and materials, underperformed.
This also means that the longer-term trend of growth outpacing value continued in 2020, with the MSCI World Value index’s underperformance of the MSCI World Growth index surpassing the lows seen during the tech bubble.
“As often happens, the reasoning that led investors to back the winners of 2020 laid the foundations for an eventual reversal. As vaccination programmes have rolled out (with varying degrees of success), the prospect of economies reopening safely has become a headwind for past winners that benefited from the work-from-home economy. At the same time, these stocks are more interest rate-sensitive, as their far-dated cash flows are hit especially hard by higher discount rates,” Baig said.
“On the other hand, the losers of 2020 now stand to benefit from the broader context: energy firms from higher oil and gas prices, financial companies from steepening yield curves, and industrials from a recovery in household and corporate demand. They are under-owned, relatively cheap, and many have only recently recovered their Covid losses.
“A handful of country indices stand out: the Russell 2000, Toronto Stock Exchange (TSX) Composite, Euro Stoxx 50, FTSE 100, Topix, and the ASX 200 each have 60-75 per cent exposure to cyclical sectors.”
Unigestion has examined the performance of country indices during time of rising real interest rates and identified some helpful comparisons with today’s market.
Performance of cyclical (blue) vs secular (red) indices in 2020 and 2021 to date
Source: FE Analytics
From 2000 until the end of 2020, a basket of the above ‘cyclical/value’ indices have outperformed a basket of ‘secular/growth’ indices (S&P 500, Nasdaq, Switzerland's blue-chip SMI and MSCI Emerging Markets) by 5.4 per cent during periods of rising US real rates on average.
Indeed, during two of these periods – namely March-October 2008 and July-December 2016 – the cyclical basket beat the secular one by more than 8 per cent.
Furthermore, the cyclical basket has outperformed the secular basket by 4 per cent over 2021 so far, but it has underperformed by 10 per cent since the beginning of the Covid shock.
This is linked to the firm’s second reason to like cyclical country indices: valuations are more encouraging in this part of the market.
“While equities are expensive across the board on an historical basis, the valuations of cyclical indices are not quite so extreme as the secular indices,” Baig said.
“For example, using a cross-sectional average of value measures, including enterprise value and price ratios, we find that the valuations of the TSX Composite and FTSE 100 are ‘only’ around their 65th percentile, while Topix is at its 68th percentile.”
He contrasted this with Switzerland's SMI, which has the most attractive valuation among the secular/growth indices but is still at its 73rd percentile.
Baig finished: “We continue to believe that rising yields are a key determinant of a sustainable rotation across assets, factors and sectors, and that faster rises will lead to a more disorderly rotation with bouts of market stress.
“Our investment framework points us toward cyclical exposures, whether in energy commodities, in currencies where we favour the Norwegian krone and Canadian dollar, or in equity indices with our preference for cyclical indices over secular ones.”