– Equity markets have seen a significant rotation over the past six months.
– There are still compelling reasons supporting the rotation, from economic recovery to relative valuations.
– The rotation may change in flavour from here, however.
The market mood has shifted notably since the announcement of successful vaccine trials last November. Investors have taken a renewed interest in a number of unloved sectors and, in particular, economically sensitive parts of the market have revived. What’s behind this change in sentiment, and can it persist?
It has been a difficult few years for investors with a “value” tilt to their portfolios. Low interest rates and quantitative easing measures have pushed bond yields lower, which has, in turn, favoured higher-growth areas such as consumer staples and technology. These conditions have been in place since the financial crisis of 2008-09, but the response of central banks and investors to the pandemic pushed the relative valuations of growth and value to extremes.
However, this changed abruptly towards the end of 2020. Thomas Moore, manager of the Aberdeen Standard Equity Income Trust, says: “A series of macro events happened that drove a reversal in bond markets, and with that we’ve seen the most enormous sector rotation.” He sees four key elements driving the shift: a surge in economic data; improving earnings in many value sectors; extreme positioning in growth sectors such as consumer staples or technology; and finally “events”, such as the vaccine roll-out, which are helping to drive recovery.
This is a global phenomenon and, if anything, the value versus growth gap has been more extreme in the US. For Fran Radano, manager of The North American Income Trust, the recent rally goes some way to resolving a long-held anomaly: “Investors will always pay a little more for companies that are growing above trend. That’s natural. What has been unnatural over the last couple of years has been the bifurcation – paying 40-50x earnings for companies that are growing, perhaps 20% and 15% next year.” Radano believes investors have started to re-appraise the fundamentals for individual companies.
For Moore, global recovery should mean the rotation can endure, particularly in the UK where the economy is bouncing back strongly. He believes that the rotation is far more than a six or 12-month phenomenon. Value areas have been out of favour for many years and the recent recovery is still in its infancy.
Equally, valuations still favour economically sensitive areas. Martin Connaghan, manager on the Murray International Trust, says that even after the recent rotation there are plenty of areas that look too expensive: “Any IPO that mentions payments or e-commerce, or investment trusts involved in a data centre, seem to be heavily oversubscribed. The same is true for areas such as data towers or infrastructure companies. We always look at whether investing in this stock helps us meet the investment objective, and if so, are we comfortable with paying this multiple.”
However, the shift may change in flavour. There are parts of the market that have seen a snap recovery but are unlikely to see improvements in earnings, and others where valuations have yet to catch up. Income stocks are one important area that has lagged. Radano says: “2020 was a horrible year for income investors. Value underperformed growth significantly, and within that, income was the worst-performing sub-sector. We have 40 stocks and only one that cut its dividend. These stocks have duration, predictability of earnings, and compelling valuations.”
Moore agrees: “Investors need to think about what type of stocks have led the rally. Lots have been zero-yielding – airlines, for example. How many income funds will hold the airlines? As an income manager, it’s quite possible to find stocks with gearing into that economic recovery, which pay a dividend.”
Both Moore and Radano favour finding cyclical companies that can also sustain predictable demand. Radano says it’s about “not betting on hope”. He likes companies such as Air Products or Union Pacific Railroad, where he sees both growth and income, rather than, say, some of the industrial companies trading at 20-30x earnings that are already likely to be at their peak.
Moore says the pitfalls for income seekers are far lower than they were: “It is important to look at dividend cover and at the potential downside. That said, we went through a pretty dramatic downside scenario in 2020. It’s also worth bearing in mind that the market is pricing in a significant margin for error where companies have problems.”
He suggests some of the better returns from here may come from the stocks where there are some concerns – where companies are paying down debt, for example. He gives the example of “survivor” DFS, which has been in a difficult sector, but has grown its market share during the pandemic: “We’ve had the ultimate stress test, and companies that are still paying dividends are likely to continue.”
The value rally can endure. However, it may look a little different, as the market re-appraises the outlook for certain parts of the economy and the excitement around bombed-out recovery companies ebbs. In particular, better times may lie ahead for income seekers.
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· The value of investments and the income from them can fall and investors may get back less than the amount invested.
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· Investment in the Company may not be appropriate for investors who plan to withdraw their money within five years.
· The Company may borrow to finance further investment (gearing). The use of gearing is likely to lead to volatility in the net asset value (NAV), meaning that any movement in the value of the company’s assets will result in a magnified movement in the NAV.
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· As with all stock exchange investments the value of the Company’s shares purchased will immediately fall by the difference between the buying and selling prices – the bid-offer spread. If trading volumes fall, the bid-offer spread can widen.
· Certain trusts may seek to invest in higher-yielding securities such as bonds, which are subject to credit risk, market price risk, and interest rate risk. Unlike income from a single bond, the level of income from an investment trust is not fixed and may fluctuate.
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Other important information:
Issued by Aberdeen Asset Managers Limited, which is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Registered Office: 10 Queen’s Terrace, Aberdeen AB10 1XL. Registered in Scotland No. 108419. An investment trust should be considered only as part of a balanced portfolio. Under no circumstances should this information be considered as an offer or solicitation to deal in investments.