Recent weeks have seen unprecedented levels of rotation in equity markets. The speed and severity of this rotation has been estimated as a 4 or even 5 standard deviation event, suggesting these types of markets should be seen, at most, once in our lifetimes.
Of course these risk figures are based on the volatility of markets over recent years, hugely supressed by massive central bank intervention, so any heightened volatility seems like a black swan event.
For those of us who remember markets before global zero-interest rate policies, then rotations such as this were a regular occurrence. In fact the S&P has only recently experienced its first 10 per cent correction in four years, an unprecedented time of market stability despite significant economic and geo-political turbulence over this period.
So it comes as little surprise that those with short memories have hit the panic button on market positioning at the first signs of some rotation. However, as economic fundamentals remain the same, or are actually worsening in some cases, it would seem unwise to chase current market sentiment. Fundamentals will soon shake out the market and see investors rotate back into those businesses that have already shown an ability to operate well despite the weak environment.
Nowhere is the current shift in market sentiment seen more than in the shares of Glencore. Having fallen steadily under the pressure of dropping metal prices and a highly geared balance sheet, the sell-off culminated with a 30 per cent drop in a day as rumours circulated over its viability as an ongoing business.
However, this selling climax seems to have acted as a catalyst for the entire mining and oil and gas sectors, and the underlying commodity prices, as all have risen sharply since. Not least that of Glencore, which subsequently almost doubled in a matter of days.
Since the trough, the mining sector rallied 30 per cent in the UK and 17 per cent in the US over the next few weeks, while oil and gas recovered by about 20 per cent in the UK and 16 per cent in the US. Meanwhile, the previous darlings of the stockmarket, such as pharmaceuticals and technology, have suffered. So does this shift represent a sustainable and real change in market leadership? Should investors be adjusting portfolios for exposure to global cyclical growth?
The evidence firmly suggests no. The decline in commodity prices has been well documented and companies that have large amounts of debt funding cyclical businesses have found themselves in an increasingly uncomfortable position. For a good year or so the commodity sector has been under pressure for sound fundamental reasons.
Slowing demand from China is commonly blamed but the biggest issue in reality is massive over-supply. During the good times, too many companies had access to too much cheap capital and over-invested, creating the current overhang in supply. Typically this takes years to work its way through and see supply rebalance with demand levels.
The latest economic news also points to a continued slowdown in demand rather than a pick-up, whether it is Chinese economic growth continuing to slow, Japanese and German manufacturing and exports weakening, or even the US experiencing a soft patch in their ongoing economic recovery. Also note recent comments from almost all industrials, particularly those exposed to China or commodities.
Optimists, however, try to justify the recent strength in cyclical sectors regardless of these fundamentals through hope that all is well. They would point to supply cuts rapidly rebalancing the industry with lower demand levels and therefore stocks are cheap. Also, that monetary stimulus will lead directly to a huge recovery in industrial demand.
Unfortunately, first, while there has been some reduction in supply in various commodities with individual mine closures, for example, none of it has been particularly meaningful. In fact, OPEC recently pumped its highest monthly production of oil for years.
Second, we have already experienced six years of extreme monetary stimulus and it has got us to the current situation. Only an extreme optimist, or a central banker, could possibly think that merely more of the same would have a hugely different impact. Given both supply and demand are certainly not in the sector’s favour and the outlook is not improving anytime soon, it would seem premature to be investing in these areas. The pain is yet to be fully realised.
On the other hand, high-quality growth businesses with a track record of delivering despite a weak economic backdrop have been sold off to rotate into cyclical sectors. In fact, anything that had outperformed consistently over the past few years has been sold to fund the cyclical rally.
These types of businesses have shown exceptional resilience to the economic cycle and have clear growth paths over the next few years, regardless of what the global economy has to throw at them. The same cannot be said about the industrial and commodity sectors. The recent rotation, far from being something to be feared, could be seen as a great opportunity to add to these strong, structural growth businesses at more attractive valuations.
The current market looks most like a normal stockmarket rotation that can unwind as rapidly as it arrived. Ignore the current short termism in the market. It is better to invest with reason rather than hope.
Jake Robbins is senior investment manager on the Premier Global Alpha Growth Fund.