Last Friday, a strong set of US labour market data surprised markets. Non-farm payrolls in May increased by 2.5m, versus street expectations for another large decline (median: -7.5m). As a result, the unemployment rate decreased from 14.7% to 13.3%.
Despite concerns raised by the Bureau of Labour Statistics that 5.4m workers might have been misclassified, and the unemployment rates in April and May should have been higher at 19.7% and 16.3% respectively, both sets of classifications would nonetheless show that the US labour market sequentially improved in the month of May. The job gains were broad-based with increases in over 60% of industries, and the greatest improvements were seen in leisure and hospitality, construction and retail.
This earlier-than-expected inflection point in the US labour market boosted market optimism that a widespread recovery is underway as economies begin to reopen. Investors rushed to add risk last Friday, and the S&P 500 rose 2.3% to close at a level of 3,194 - which is only 6% off the all-time high of 3393 on 19 Feb 2010. The Nasdaq hit its all-time historical high of 9846 during last Friday’s trading session, before closing at 9,814 - up 2% day-on-day. Safe havens such as gold, the Japanese Yen and US treasuries depreciated. The 10Y treasury yield increased 7bp to 0.90%.
Since mid-May, increasing optimism over the post pandemic recovery has driven an equity rotation from Growth and Defensive sectors, which has led the rebound that started in late March, into Value and Cyclicals which includes sectors such as financials, industrials, airlines, autos, energy and real estate.
Uncertainties due to the Covid-19 pandemic have driven the performance spread of Value versus Growth to record levels. With incoming data increasingly confirming a recovery, investors are rotating into Cyclicals and Value with the view that these lagging sectors would outperform as their fundamentals benefit from an economic upswing.
The rotation we see today is in line with the observation that periods of Cyclicals and Value outperformance typically take place when 1) growth data turns the corner in bear markets, and 2) when bond yields rise as investors discount for higher rates ahead alongside an improving growth outlook. Both sets of conditions are in place today. As countries and cities continue to ease containment measures and reopen for business, we expect sequentially improving data to further spur the rotation in leadership towards Cyclicals and Value stocks.
Broadly, we see Europe and Emerging Market (EM) equity markets to be beneficiaries of the rotation into Cyclicals and Value, as these markets are driven significantly by sectors such as Financials, Industrials and Energy. In contrast, the US market is dominated by Technology – to illustrate, five tech stocks make up about a whopping 20% of the S&P 500’s total market cap – which helps explain why the overall performance of Europe and EM markets has lagged S&P 500 from end March to mid-May.
For EM Asia equities, however, investors ought to be cautious that although the rotation into Cyclicals and Value would be a positive factor, rapidly escalating US-China tensions are poised to be a major market tailwind again (see “US-China Tensions - Gloves Coming Off Again”). The lesson drawn from the 2017/18 trade war is that EM Asia tends to suffer a greater negative impact relative to US and Europe.
Another factor likely to drive rotation into Cyclicals and Value stocks in Europe and EM is easing USD strength. The dollar index has depreciated about 3.5% since mid-May, and our currency strategist Sim Moh Siong expects more USD weakness over the next 6-12 months as the erosion of the USD’s yield advantage and a massive fiscal deficit weigh on the US dollar.
Moreover, if there is a V-shaped economic recovery, we see the USD with the largest scope to decline versus commodity currencies, which are best positioned to gain from higher commodity prices in a sharp economic rebound.
In our view, this ongoing rotation in equity leadership to Cyclicals and Value has some room to go as economic data improves ahead, but it is likely to be a tactical trend rather than a structural one. Since the Global Financial Crisis, the 15 rotation into Cyclicals have lasted only four months on average, with a range of one to nine months.
We believe that the overall outlook has incrementally improved with incoming data confirming that the worst of the pandemic’s economic impact is behind us. We continue to hold an overall equal-weight view on equities and an overall overweight view on fixed income, through EM high yield bonds.
Considering the risks related to potential second waves of Covid-19 infection, the uncertain path back to 2019 levels of economic production, the 2020 US Presidential Election, rapidly escalating US-China tensions, and the fact that valuations have likely priced in a large part of the positive market factors today, we do not believe it is time to go overall overweight on equities, and would focus on selective opportunities in the equity universe that are likely to benefit from the rotation into Cyclicals and Value.Disclaimer applicable to recommendation
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Version: March 2020