One of the more interesting developments of the year so far has been the changing dynamics within equity markets.
To the casual observer the year could be split in two, simply explained by changing perceptions of the prevailing macro backdrop. The first six weeks a classic “risk off” environment, where defensive characteristics outperformed as investors worried about fading signs of global growth and the potential for a deflationary funk to set in.
Then, from mid-February, a rebound in the more “risky” areas of markets, as such worries subsided somewhat – at least for the time being.
Looking closer, however, things have not been quite as clear-cut. Indeed, one of the most striking phenomena has been the tentative outperformance in mining and commodity-related sectors (that is, “risk”) as the year has progressed.
Not just since the troughs of February but more persistently from mid-January, even as markets continued their merry march downwards. For instance, the mining sector in the UK has returned near 50 per cent since then – definitely not what most expected.
Markets often have a habit of showing us things before the wider investor community realises anything is happening. For those with good memories, the start of 2009 is an interesting example. Before the market bottomed in March “riskier” cyclical shares started outperforming, even as the market continued to fall and macro concerns abounded.
That is not to say we believe current conditions are a mirror image of 2009. Far from it. However, there is similarity in the degree to which investor positioning has become skewed and how any deviation from such common consensus can lead to powerful, possibly counter-intuitive, moves within markets.
Returning to this year, it is noticeable how few market participants appear to be actively trading. The majority appear wedded to their positioning of recent years: the bull market in defensive, quality growth that has been so evident.
This ties in with the observable performance of actively managed funds this year, particularly in the UK. In 2015, being underweight “risk” (predominantly mining and financials) saw most active managers outperform the FTSE 100 comfortably. This year, the reverse is true. The index, with its overweight to such risk, would be firmly first quartile; the average active manager significantly behind. All this points to a degree of inertia.
So, what could be occurring to warrant such unexpected moves in markets? Should we just ignore this as a short-term bounce in “trash” before we resume the pattern of recent years?
Two of the stronger forces impacting both the global economy and markets – the US dollar and the oil price – have been spoken about considerably in recent times, in particular how a stabilisation or reversal of either could change the outlook for investors quite materially.
Common consensus would tell you we are in a world of secular stagnation, where global growth hobbles along and deflation is ever more baked in. A world where ongoing monetary easing and competitive currency devaluations from central banks allows the playbook of recent years to carry on unperturbed. The dollar remains strong and defensive; quality companies exhibiting growth will be rewarded. A slowing China puts only downward pressure on all things energy- and commodity-related.
Recent market reactions to new policy initiatives perhaps suggest something else, though. A comparison to 2011 is an interesting one. Back then everyone “knew” the US dollar would remain weak. Until, of course, it did not despite ongoing money printing at the time. Now investors are convinced of the opposite.
But where once a strong US dollar was considered good for the global economy, perhaps we are now entering a phase where it is more harmful. The market might well be already sniffing this out.
Take the most recent examples of global policy action. Deposit rate cuts in Japan in February did not see the expected subsequent weakening of the yen. Indeed, the currency strengthened markedly. Even the recent announcement of additional easing from the European Central Bank saw the euro weaken for just half an hour before it about-turned.
Has the market realised a game of currency devaluation does not necessarily work from here? As such, will policy become more nuanced to engender growth rather than just force the domestic currency down to gain a competitive advantage?
If the bull market in the US dollar is diminishing, many investors will need to re-evaluate their positioning, skewed as they are. A more stable dollar may begin to ease current pressures on emerging markets and thus soften the deflationary fears that dominate. Indeed, it may warrant exposure to those areas that have suffered in the wake of its strength – even energy- and commodity-related sectors.
Of course, we have sympathy with the longer-term concerns about global growth. Many of the issues above will undoubtedly create tougher conditions ahead, both in economies and markets. However, we are simply observing that at this juncture investor positioning appears to have become meaningfully skewed. The crowded areas appear fully valued; the current pariahs at levels that seemingly reflect many of the associated risks. And for longer-term returns, valuations do matter.
This valuation conundrum is why we believe a barbell of selective, value-oriented equity and cash is a prudent spread of risk at this juncture. We acknowledge we may not be at the end of this period of volatility and the direction of travel in either direction is not certain from here. But we are mindful that valuation risk is a significant one for longer-term investors. The balance of risks suggests a portfolio away from current common consensus is the right one.
Joe Le Jehan is fund manager on the Schroders multi-manager team