TheChek News Flow

Rotations are a constant feature beneath the surface of markets and nothing quite animates conversation at the moment than the prospects of a bigger shift into “value” or cheap areas of equities. This is a global equity story that also meshes with a theme that will define the coming decade: the next industrial revolution.

The latest equity rotation towards value dates from mid-August when long-dated sovereign bond yields set their lows for the year.

Over at JPMorgan, its global quantitative and derivatives strategy research says the shift towards value is only phase one, and one largely driven by a bounce in shares from very cheap levels. In terms of the S&P 500 index, JPMorgan thinks “only ~20% of the momentum/value rotation is complete” as charted below. The bank also estimates: “Europe follows with ~15% of the rotation complete, while in Asia and Japan the rotation has barely started.”

In recent conversations with a number of investors, the general view is that the attraction of value can hold for three to six months, and then lapses, repeating a pattern of brief rallies over the past decade. In turn, owning growth companies is still viewed as an appealing strategy against the backdrop of a slowing global economy. Sticking with high-quality and defensive companies also has its allure, given that trade and political risks remain high. 

Ultimately, the question of a sustained tilt towards value (where financials have an outsized presence) boils down to whether the global economy finds a firmer footing that extends the current business cycle. That, in turn, entails long-dated bond yields climbing higher and yield curves steepening.

Such a scenario does not just bolster value and cyclicals, it tends to pressure growth stocks, as the attraction of companies in expansion mode and with pricing power is desirable against the backdrop of sluggish economic growth and disinflationary winds. Momentum stocks, or those with low volatility versus the broader market, also suffer when yields start rising as they no longer look so appealing. 

JPMorgan makes the case that “the second phase should be propelled by better macro-fundamental data and cycle recovery”. The banks adds:

“Recovery of the global business cycle (and by extension global bond yields) is essential for the rotation to continue. For the first time in 6 months, our three regional business cycle indicators (QMIs [Quantitative Macro Indices] for US, Europe, and Asia) are in recovery/expansion.”

Now there are plenty of doubters about the merits of a sustained global upswing in 2020. That said, it won’t take much to lift companies that are barometers of economic activity next year. 

In terms of cyclical industries’ profits, Steven Wieting, global chief investment strategist at Citi Private Bank, says they have raised “US and global 2020 [earnings per share] expectations from 4% growth to 7%”. He adds:

“Of course, this could be exceeded, as the experience of 2017 showed. However, our forecast is consistent with at least a narrow agreement being struck to avoid tariff escalations between the US and China and the US and EU in the coming year.”

But there’s another important angle for investors: the coming era of industrialisation; one transformed via advances in artificial intelligence, big data, automation and 3D printing, and what this ultimately entails for “old economy” companies based in that sector.

A few months ago Steve Blitz at TS Lombard certainly made me think when he outlined at a London seminar how the average age of US fixed assets was the oldest since the 1960s. That, according to Steve, reflected a manufacturing sector waiting for the new wave of robots and automation, and all seamlessly connected via a 5G network. That is not good news for human jobs, but likely means more goods eventually being produced in the US, given the big cost savings. 

This coming transformation and boost in capital expenditures in the next decade was very much a part of a recent conversation I had with Frédérique Carrier at RBC Wealth Management. This week RBC published its 2020 outlook, which includes a section looking at the new industrial revolution and how it stands to transform “the investment outlook for the Industrials sector”.

“Advances in factory automation could be reaching the point where ‘lights-out’ manufacturing plants become widely feasible” and “today we are seeing a deluge of new applications for robotics and automation”.

Other game-changers are smart systems that stem “rampant water leakage” for utilities, while advances in 3D printing are another important driver of efficiency gains.

Such promises come while investors show little love for the sector. As shown below via RBC, the S&P Industrials sector is certainly cheaply valued relative to the broad market, languishing near its lows plumbed during the global financial crisis.

This raises the prospect of both short- and longer-term opportunities for investors willing to do their homework on the sector. 

Frédérique makes a couple of contrarian points for the coming year:

“The industrial sector tends to outperform when value beats growth. It is less vulnerable to fears of a potential Democrat sweep in 2020 than other cyclical sectors. Industrial companies are also actively buying back stocks and could benefit should the trade war enter a détente phase in 2020, ahead of the presidential elections.”

And taking a longer-term view, Frédérique adds:

“Today’s heavily discounted valuations within the Industrials sector make this an especially opportune time to seek out the groups and companies that are likely to establish competitive advantages in this transforming industrial world.”