Rebound or a real rotation?

Will the drone attacks on oil facilities in Saudi Arabia put an end to the optimism that has returned to the markets since the start of September? Hard to say but - to date - the US and European indices remain close to their 2019 highs. As investors sometimes say, “So far, so good.”

Fund Commentary
18 Sep 2019

Will the drone attacks on oil facilities in Saudi Arabia put an end to the optimism that has returned to the markets since the start of September? Hard to say but – to date – the US and European indices remain close to their 2019 highs. As investors sometimes say, “So far, so good.”

In the first half of September, the market recovery since the summer’s lows can be attributed primarily to a sector rotation (or we should say factor rotation, as nowadays quant strategies are everywhere!). Value and cyclical stocks, which were pariah stocks for a number of years, seem to have regained investors’ favour. The banking sector index has gained 10.9% in three weeks, just like the index of auto parts suppliers.

At the origin of this rebound, we have a modest rise in long-term interest rates, a trend which – understandably – is generally associated with a rise in the price of banking stocks, but also – and this only comes gradually – a rise in the stock price of participants in the automotive sector. The connection comes from the cyclical nature of the sector and the now-familiar behaviour of the investors who rush into the banking sector when interest rates rise, and exit it in droves on the contrary, when interest rates drop and buy growth and so-called quality stocks (i.e., stocks which have a higher visibility with regards to their future revenues).

Since the financial crisis of 2008, central banks have tirelessly pumped money into the financial system in order to bring down interest rates. The observed increase in interest rates has so far been small and consequently, the rebound of “value” stocks, similar to the recent rally, has always been short-lived. In fact, both value and cyclical stocks continue to linger in a downward trend, whereas growth stocks have gone from one record high to another. If the small rebound at the start of September behaves like the most recent ones, then it will also be short-lived and we can close this chapter believing that there is “nothing new out there.” Or can we?

We will not stop on this note, because even if we admit that the catchphrase of “this time is different” can cost investors dearly, we really need to check the facts before concluding that nothing has changed.

First of all, we can easily rule out the assumption that there is an impending shift in central bank policies because this will not happen. Even if there was a sense of resignation in Mario Draghi’s demeanour during the most recent meeting of the ECB, he stayed the course of more negative interest rates and Quantitative Easing… It is therefore not from a change of central bank policy that an explanation will be found to account for the sector rotation that has been observed.

So let’s forget interest rates for a moment (a difficult exercise, given that they are the main building block in the valuation of assets!) and consider this sector rotation from another perspective: that of the industry sector or more precisely, the German manufacturer. It is feared that the morale of CEOs and CFOs of German manufacturers is currently very low. The PMI index of -44%, published by the ZEW institute (which measures the German Purchasing Manufacturers’ Index), shows a level last seen in 2011 and 2008!

It appears that German manufacturing, especially the car industry, are the first casualties of the Sino-American trade war; there was no reason for the manufacturers to celebrate in the past few months. So could it be that these manufacturers are missing something which is cheering up investors?

Maybe. Two things come to mind: the first is that for the first time the German authorities appear to be relenting on fiscal orthodoxy and are (timidly) contemplating a fiscal stimulus. Mario Draghi has been strongly advocating this, stating that “governments that have room for manoeuver must act quickly.”

The second reason is the countdown to the US elections. Even if everyone accepts that Donald Trump is sometimes unpredictable, there are two things that consistently remain at the forefront of his thinking: the level of the S&P 500 index and his popularity level in the opinion polls. While voters initially viewed the trade war positively, this sentiment is changing as the domestic impact is felt and individuals are starting to suffer as a result of increased tariffs. Extracting concessions from the tenacious Xi Jinping is suddenly proving more difficult, and more expensive too… As for the markets, they always react badly to the bursts of angry tweets from Donald Trump, and as this summer’s scenario confirms, he always seems to tone down his threats as soon as the S&P’s decline exceeds 5%.

The market rebound of the last few days is therefore not derived from new information with regards to interest rates, but probably it is a direct bet that the economic slowdown caused by the trade war in recent months is gradually coming to an end. This would mean that the economy, and especially the manufacturing sector, is on the path to recovery because valuations in the manufacturing sector have been in the doldrums for quite a while, even a timid pickup in economic activity might translate into significant upside potential.

The views and statements contained herein are those of Marc Craquelin as at 18/09/2019.

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