Weekly Market Update (November 16, 2020 – November 20, 2020)
By: Angelo Kourkafas, CFA® November 20, 2020
Last week saw the equity markets performing a balancing act between incoming positive vaccine news and ever-growing economic restrictions aimed at curbing the recent spike in virus cases and hospitalizations. The rotation out of the technology sector and into more cyclicals stocks continued, as the vaccine developments improved investor sentiment and confidence about next year’s outlook. The jobs-data release showed worse-than-expected initial jobless claims, which, in our view, confirms that this economic recovery is likely to be choppy before ultimately returning to pre-pandemic levels. Reports that the Treasury department is not extending certain funding for the Fed’s lending facilities established earlier in the pandemic is catching attention, though we don’t interpret this as a signal that monetary-policy support will be significantly or permanently scaled back.
Market Rotation: What Is It? What Drives It? And Will It Last?
A central theme in equity markets over the last two weeks has been the so-called rotation, or change in leadership across asset classes, sectors and investment styles. We received a series of positive vaccine announcements, first from Pfizer on 11/9, then from Moderna last Monday, and then from Pfizer again last Wednesday on the final results of its late-stage trial. This news propelled the S&P 500 to a new all-time high, before the rally fizzled later in the week on deteriorating coronavirus trends. The near-term outlook is also worsening because of the renewed restrictions on activity. As the market attempts to balance this weakened near-term outlook against an improving medium- to long-term outlook due to the vaccine developments, we see this tug-of-war likely continuing between the year-to-date leaders and the economically sensitive investments that have lagged. Below are some thoughts on the recent market rotation, its drivers, and its sustainability potential.
- Leaders and laggards trade places – Technology stocks, growth-style investments, and stocks that benefit from the “stay-at-home” trends not only held up better during the pandemic-induced bear market, but have also led the market since the March bottom. However, the recent vaccine developments acted as a catalyst for the recent shift in the investment landscape, as confidence in the economic rebound strengthened. Cyclical sectors, like energy and financials, which have been negatively impacted by the pandemic and are more sensitive to the reopening of the economy, outperformed, while sectors that have benefited from the pandemic, like technology and communication services, lagged. A similar rotation occurred across asset classes, with small-cap and international investments outpacing U.S. large-cap investments. Investment styles were affected too, with value (dividend income) outperforming growth (capital appreciation). As the table below shows, the last two-week performance across different investments was almost a mirror image of the first eight months of the year. Among many notable moves, the tech-heavy Nasdaq had its worst day against the S&P 500 since the Great Financial Crisis, value outperformed growth by the largest margin in history on 11/9/20, small-cap stocks surpassed their previous high set in 2018, and Japanese stocks hit their highest level in almost three decades1.
- Economic growth and interest rates are the key rotation ingredients – Over the course of the last bull market (2009 – early 2020) that was interrupted by the pandemic, there were several periods of rotation towards value-style and economically sensitive investments, but they proved short-lived, as the economic expansion was characterized by slow growth, low interest rates and subdued inflation. When economic growth is slow and interest rates low, investors tend to favor companies with the ability to grow earnings at a faster pace than the market in general and that typically trade at higher valuations, like stocks in the tech sector. On the flip side, accelerating economic growth and rising interest rates benefit sectors like industrials and financials, respectively, both of which are heavily weighted in international, small-cap and value indexes.
- Sustainability of rotation likely time-frame dependent – The vaccine developments reinforced our view that the economic recovery will be durable as we head into and through 2021. We believe there is good chance that next year will showcase investors the benefit of owning a properly diversified portfolio with exposure to not only U.S. large-cap tech stocks, but also small-caps, international and cyclical sectors that have lagged. Pent-up demand, an accommodative Federal Reserve, and rising earnings all support a constructive outlook and the broadening of the market rally. However, in the near term a lot of risks and uncertainties remain, including potential vaccine setbacks, along with logistical challenges with production, distribution and take-up of the vaccine from the general population. Below are some thoughts on how the evolving trends in corporate earnings, medical solutions, and the path of the virus might affect the relative performance of different asset classes over time.
- Near-term: The resurgence in coronavirus cases and record U.S. hospitalizations, along with new restrictions in several states, are a reminder that the near-term path to a full economic recovery will be bumpy. With broad lockdowns in Europe, economic activity and mobility have taken a hit, threatening to stall or possibly reverse the recovery. Fourth-quarter European GDP could have a negative sign in front of it, while the U.S. could experience very muted first-quarter GDP growth. Current corporate-earnings trends continue to favor tech stocks and growth stocks, but the market could potentially look through near-term weakness in cyclical stocks, knowing that there is a vaccine endgame. Summing up, the performance of economically sensitive investments might remain challenged in the short term but be more balanced relative to “stay-at-home” stocks, compared with what we saw in the early stages of the pandemic.
- Medium-term: Wide distribution of a vaccine will accelerate the economic reopening and return to normalcy, unleashing pent-up demand, particularly for services (travel, leisure, food & accommodation services). The improved growth outlook will benefit economically sensitive sectors and asset classes, opening a window of outperformance, in our view, likely towards the second half of next year. Additionally, unlike tech and growth stocks, cyclicals will face some easy earnings comparisons next year and trade at discounted valuations. If the recovery is sustained as we expect, long-term interest rates have some room to rise modestly, assisting the performance of financials. However, the Fed’s extraordinary accommodation over the next few years will act as an anchor, preventing a sharp move higher.
- Long-term: After the pandemic is behind us, the new normal might be a little different, as the digitalization and stay-at-home trends that have accelerated over the last seven months are likely to have staying power and continue to benefit disruptive companies. While comparisons get harder for tech next year, the sector’s earnings growth between 2020-2022 is still expected to easily outpace pace the growth rate for the market in general. Longer-term, in a world of relatively low interest rates and slow population and productivity growth, investors are unlikely to shy away from areas that can grow faster than the economy.
We believe the recent market rotation provides an opportunity for investors to evaluate portfolios and rebalance if overexposed to a certain asset class, sector or investment style. As confidence about the return to normal economic conditions increases, and as the expansion facilitated by medical solutions extends into the future, we anticipate additional rotation into economically sensitive and cyclical investments. That said, we doubt the rotation will be consistent or uninterrupted, which is why we recommend investors maintain appropriate diversification that can help navigate the path ahead.
Angelo Kourkafas, CFA
Investment Strategy Analyst
The Week Ahead
Important data being released this week include personal income and spending breakdowns, FOMC minutes, and building permits.
The Weekly Market Update is published every Friday, after market close.
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