«Economic tail wind»
Last year, the revival of global economic growth led to massive rotation in the financial markets. After years of weak economic growth, key leading indicators were suggesting mid-year that the global economy had bottomed out – and growth would pick up again. Many investors had almost given up on the idea of a revival of economic growth.
That’s why the Merrill Lynch Fund Manager Surveys showed investors being very defensively positioned in sectors such as cyclical consumer goods or pharmaceuticals. Up to the end of the third quarter, the consensus among investors was to be underweight in cyclical stocks and sectors because of the gloomy outlook for growth.
They were wide of the mark. Using style and factor tracking, we found that, among the major markets, it was the emerging markets that switched to recovery mode first, followed by Japan and the United States, then Europe last. During the course of the year, market players increasingly sold expensive defensive stocks and bought cheap cyclical stocks because these were more likely to participate in the global upswing.
Low valuation, high risk, low quality and low size (small and mid caps) strategies belong to a quantitative cyclical positioning. Due to the economic revival, stocks that belong to these styles are currently seeing significantly higher earnings revisions than stocks with defensive style characteristics such as high quality and low risk.
The closely followed Purchasing Managers’ Index (PMI) has been rising sharply for months in most countries and is a reflection of businesses’ newfound confidence. Since November, market players have been taking a more cyclical position again in the hope of there being a massive fiscal stimulus from Donald Trump’s proposed economic policy.
«Synchronous economic recovery in the key major regions»
The economic cycle models that we use for our analyses expect growth to accelerate considerably in all the major regions over the coming months. This means new leadership roles when it comes to regions, countries, sectors and stocks. In the next one to two years – that is how long a recovery takes on average – a return to the cyclical market segments is likely to bring the years of dominance of the defensive segments to an end.
We regard the emerging markets and Europe as cyclical regions; the United States, by contrast, has proved to be a very defensive region in the past. Donald Trump’s policies, however, are likely to particularly favor US small and mid caps with primarily domestic exposure.
Sectors such as banks, insurance, materials and technology are likely to outperform the defensive health care, consumer staples and utilities sectors under the new economic cycle model.
This pronounced rotation has been sudden, as so often in the past, and caught many investors completely by surprise. This is why certain market players are likely to have reservations about making new commitments to cyclical strategies even though they have already massively outperformed defensive strategies during the past few months.
Assuming Donald Trump does not foment an economically damaging trade war or is prevented from doing so by Congress, the cyclical upswing could even last for several years. If a recovery, like in 2003, is followed by a phase of sustained strong economic growth, like in the years 2004 to 2006, then a cyclical style strategy such as low valuation or low size could be profitable for up to four years or longer. We are probably witnessing the dawn of a new economic regime, but no one quite believes it. This will provide many market opportunities.
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