To Believe In The Rotation Or Not To Believe…

To believe in the rotation or not to believe in the rotation, that is the question for fund managers staring at a tide which appears to have turned in favor of Value and Cyclicals amid rampant trade optimism and the assumption that eventually, the coordinated global easing push executed over the past nine months will show up in the economic data.

The problem, though, is that there is no guarantee that the global economy will in fact inflect for the better and dodge a deeper downturn. Indeed, the likes of the IMF and the OECD continue to express more than a little consternation when it comes to outlook for global growth and trade.

Meanwhile, the jury is still out on whether fiscal stimulus will be anything other than piecemeal and sporadic across disparate locales. There’s movement, to be sure (e.g., India), and German officials continue to insist that in an “emergency”, Berlin will loosen the purse strings. But judging by the increasingly desperate tone from central bankers and still depressed bond yields in developed markets (this month’s selloff and accompanying yield surge notwithstanding), nobody is any semblance of convinced that a coordinated fiscal push is imminent. All in all, global growth is still expected to clock in at the weakest since the crisis in 2019.

(IMF forecast as of October 15)

And yet, if you’re looking for the next trade, it’s hard to ignore the possibility that surging bond yields will continue to fuel a rotation in favor of Value and Cyclicals.

The assumption is that once the “Phase One” trade deal between the US and China is in the books, yields can rise further, extending the rotation that’s played out under the hood in equities (to dramatic effect in early September and then again more recently).

“The dilemma for fund managers is whether to commit more assets to Value stocks — inherently more cyclically exposed — at a time when global earnings momentum has turned negative, or whether to hold on and wait for a Value correction, as we have seen three times already this year”, SocGen’s Andrew Lapthorne writes on Monday, underscoring the other worry – namely that profit growth has decelerated.

But the risks of jumping on board with cyclical exposure just as things take another turn for the worse notwithstanding, the bigger danger may be hanging around in absurdly crowded bond proxies and overextended equity expressions tethered to the now fading “duration infatuation”.

(SocGen)

Lapthorne underscores that as well. “We highlighted this ‘bond proxy’ risk somewhat fortuitously in mid-August this year and the message still stands; expensive higher quality stocks are at risk of either improving economic sentiment or from being too expensive to withstand an equity market downturn”, he notes, adding that “last summer a ‘sensible’ asset allocation would [have been] US bonds + Global Value as the former protects you in a slump, while the latter provides you with economic upside potential”.

Whether or not that’s still a good strategy remains to be seen. In a rosy scenario that sees recent optimism extended, that allocation risks a situation where the gains that would presumably accrue from leaning into Value would be wiped away by a long UST position against a continuation of the recent bond selloff.