Friday, November 27th, 2020

How the World Turns

In our last report, we explained how we looked at the topic of sector rotation within equities, using three metrics:

  • Rotation: the gross total change in recommended sector weights resulting from our weekly rebalancing. We quote this as a four-week moving average (MAV);
  • Inflection: the point at which the 10-week MAV of the sector’s recommended weight (equivalent to 50 days) moves from a positive to a negative gradient or vice versa;
  • Persistence: the tendency for sectors maintain their position relative to other sectors; specifically, the number of consecutive weeks a sector spends in the top or bottom three of our recommendations.

This report is a survey of what’s happening on the ground in real time, and perhaps more importantly, what isn’t happening or hasn’t happened yet. The bandwagon of style rotation is starting to roll very fast, which carries its own set of risks. The last report focussed on the US and Pan Europe, so this one spends more time on the other regions, Japan, China, the UK and the Eurozone.

Inflection points: By definition, this is a lagging indicator, but it highlights the point that there many occasions when a sector looks as though it may change direction, but doesn’t. Using our models, there are only five regional sectors where we can identify an inflection point within the last four weeks. They are UK Financials from down to up, Japanese Consumer Services and Utilities from down to up, US and China Consumer Discretionary from up to down. There are another four where the signal is likely to change in the next four weeks: Chinese Energy and Financials from flat to up, UK Energy and Consumer Goods from flat to up. Other candidates, like Eurozone Financials, may well turn up in the near future, but the inflection point in the 10-week MAV is unlikely to happen before next year.

Most of the inflection points on the downside, particularly in Healthcare, Technology and Utilities, actually happened in September and October in our models, so we are slightly puzzled as to why everyone else has just woken up to them. The previous wave of upward inflection points for Industrials and Small Caps in certain regions happened in July and August and is old news as far as we are concerned. A cynic might suspect that many strategists missed the rotation in its sector form and have rebadged it in terms of style and factors, some three months later.

Rotation: It should be obvious that each region will rotate at different speeds. By far the most aggressive rotation is in the UK, which has benefitted from at least four bits of good news in the last month: the Bank of England’s guidance that it will not use negative interest rates, the resulting strength of sterling, increased likelihood of a Brexit deal and the vaccine from AstraZeneca. The gross overall change recommended by our models is 75%, compared with 64% for the Eurozone and an average of 43% for the other three regions. US, China and Japan. These numbers look high, but our models are unconstrained by any formal exposure limits, so the impact on client portfolios would be much lower.

The sectors most affected by rotation also vary from country to country. The biggest losers in the last four weeks are as follows: Consumer Discretionary in the US and China, Telecom in Japan, Technology in the UK and Eurozone. The only inflection points in the last four weeks are for US and Chinese Consumer Discretionary. The biggest gainers are Financials in the UK and the Eurozone, Small Caps in the US, Consumer Discretionary in Japan and Energy in China. Here the inflection points tend to be more recent, or still in the future, as in the case of Eurozone Financials.

We can also identify the sectors in each region which have changed the least of the last four weeks: US Energy, UK Industrials, Eurozone Telecom, Japanese Energy and Chinese Financials. This is an interesting list because it contains many companies which would naturally fall into the value category. At the very least, it suggests that future returns attributed to the value factor will not be uniformly distributed within the value universe. In other words, the value trade will work in some sectors, but not in others.

Summarising on a global sector basis: the biggest losers over the last four weeks have been Technology and Healthcare. The biggest winners have been Financials and Small Caps. The smallest movers have been Materials and Telecom. Health and Technology have been reduced in every region, but there are no sectors where there has been an increase in every region. But there are narrow misses for Financials, which have four up moves (excluding a small down move in China) and Japan (excluding Energy).

Persistence: This is a measure of how much has stayed the same at the top and bottom of the rankings for each country. This is a non-story. No region has had more than one new entrant into the top and bottom three over the last four weeks. For instance, US Technology is still in the top three. We are confident that it will drop out soon, but we made that call back in October. Most of the action has been sectors which are in the middle of the table. Our list of small movers includes several country sectors, which are in the bottom three and likely to remain there for some time to come.

Action recommendations: We agree with some of the consensus view on rotation. We are reducing exposure to Technology in every region, as well as its fellow traveller Consumer Discretionary in the US and China. Reducing exposure to Healthcare is equally important, even though in some regions the valuation is not excessive. We agree with the move to increase exposure to Financials, especially in the UK and Eurozone, but we are still reducing an underweight rather than building an overweight. We are happy to reduce the underweight in Energy, but a move to neutral would require the oil price to back to $55/bbl and stay there. If it doesn’t, the rally will fail. We agree with the move into Small Caps in the US and all of Europe, but not Japan or China, where there are better opportunities in Consumer Good/Staples, neither of which score well on a traditional value screen.

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