Sectors usually associated with a strong economy have rallied hard in recent weeks, creating questions over why investors are so bullish in the middle of one of the sharpest recessions on record. 
Global stocks were plunged into a bear market at the start of the year as the coronavirus pandemic spread around the world. Between the market peak on 19 February and 23 March, the MSCI World dropped 25.57 per cent.
As would be expected, cyclical stocks – or those more linked to the health of the economy – were hit harder than their defensive peers. FE Analytics shows the MSCI World Cyclical Sectors index fell 27.01 per cent during the sell-off.
Performance of global stocks in coronavirus crash
Source: FE Analytics
As countries pushed their populations into lockdown to slow the spread of the outbreak, activity ground to a halt and the global economy contracted. The UK economy, for example, shrank by 2 per cent in 2020’s opening quarter – on the back of just one week of lockdown.
The second quarter of the year will have witnessed an even larger economic contraction, while unemployment has climbed to high levels in many parts of the world and consumer confidence has tanked.
However, stock markets started to climb again on 23 March (the day the UK went into lockdown) as sentiment was buoyed by the massive levels of fiscal and monetary stimulus unleashed to shore up the global economy.
Given the nervousness around the health of the economy and the fact that the coronavirus pandemic has far from ended, defensive stocks led the initial rally. But over recent weeks, cyclical stocks have posted an impressive return.
Performance of global stocks over 1 month
Source: FE Analytics
But what is driving this strong rally in riskier parts of the market, especially amid the continued economic weakness and high levels of uncertainty caused by the coronavirus pandemic?
Paul O’Connor, head of multi-asset at Janus Henderson Investors, said: “The frantic rotation in market leadership over the past three weeks has seen the liquidity-driven rally mutate into a full-on reflation trade.
“The price action in global markets during the first eight weeks after the March low in global equities suggested markets that were being driven by faith in central bank liquidity provision, rather than having much confidence in global growth. Perceived defensive assets such as government bonds and gold rallied alongside risk assets. In the equity markets, secular growth areas, such as technology and pharmaceuticals outperformed value stocks and cyclical sectors.”
O’Connor pointed out that cyclical and value sectors such as banks, autos and steel have surged in all the major markets, massively outperforming the growth stocks and defensives that were the previous winners. On a geographic basis, areas like Brazil, Russia and Europe are well ahead of the US while UK small- and mid-caps are beating the FTSE 100.
“The last three weeks has seen a dramatic change in market leadership,” he added. “Inspired by the reopening of economies, some better economic data and a continued flow of stimulatory global policy initiatives, investors have pivoted away from the areas of the market that led the first leg of the recovery into the laggards.”
Performance of global sectors over 1 month
Source: FE Analytics
Unigestion described the rally in risk assets as “one of the sharpest in history” and argued that several factors suggest this could continue for some time.
Among the turning points that the asset manager thinks could “trigger a breakout in risky assets” are an improving macro dynamic (“the worst seems to behind us”), investor positioning (“cash positions are at record highs”) and asset valuations (“it seems difficult to see any bubble pricing currently”).
The firm said that last Friday’s US jobs report is “the perfect example of how markets could be surprised by the pace of the recovery”. Economists expected it to show 7.5 million job losses but the US created around 3 million new jobs.
Olivier Marciot, senior investment manager at Unigestion, said: “Thus far, June has seen a continuation and acceleration of the themes observed in April and May: an improving macroeconomic situation and fast-recovering investor sentiment.
“Newsflow on the pandemic has materially improved, economic data is less negative and a shift out of safe assets into growth and inflation-related assets is gaining momentum. Compared to the last few weeks, the rally seems broader-based, taking the shape and form of a more traditional recovery driven by a ‘risk-on’ event, with most risk assets thriving at the expense of hedge assets.”
Against this backdrop, Unigestion has given its portfolios an increased tilt towards assets related to growth, such as equities, combined with reduced short exposures to real assets and a reduction in defensive plays such as government bonds.
Performance by geography over 1 month
Source: FE Analytics
Not all investors are convinced that the recent risk rally is built on a solid foundation, however. Waverton Investment Management is running an underweight to equities and fixed income, while being overweight alternatives (to make up for its bond underweight) and cash.
Waverton chief investment officer Bill Dinning said: “We suggest though that what we are seeing so far could be called ‘The New Stagflation’. Stagflation is generally defined as a stagnant economy and sharply rising prices. In the 1970s the prices that were rising were of goods. Today the prices that are rising are of financial assets. We question how long this can persist.
“Our cautious stance continues as we fear that the current levels of liquidity being provided can delay a solvency crisis but cannot postpone it indefinitely. We fear that over the summer the true level of strain caused by lockdown policies and social distancing will become more visible in markets as defaults become more commonplace.”
Janus Henderson’s O’Connor also warned investors that further bad news could be on the horizon. While there are some factors that could push the rally on further – such as the vast amounts of cash in investor portfolios waiting to be deployed – he believes it is far from certain that recent market momentum can be sustained.
“Although the last leg of the rally has seen some speculative froth emerging, investors generally remain defensively positioned both in terms of their overall asset allocation and their sector exposures,” he said.
“While this would suggest that both the rally and the rotation can extend further, sustained advances require continued support from the news flow on the economy and the coronavirus. The market moves of the last few weeks have priced in a lot of positive developments.
“It would be no great surprise to see a period of market consolidation now as investors await decisive news on the coronavirus front to determine the direction of the next big market moves.”