After rallying broadly for the first half of 2019, defensive assets have petered out since early September. Not all areas of the market have been lackluster, however, with cyclical segments delivering strong returns. Regionally, higher-beta1 equity markets outside the US are outperforming as well.
What’s going on? In my view, a collection of factors is fueling the rotation to cyclical outperformance.
First, investors remain very defensively positioned. As Figure 1 shows, investors are heavily weighted toward low-beta sectors such as real estate investment trusts (REITs) and consumer staples; “safety” asset classes such as cash and bonds; and lower-risk regions such as the US. Meanwhile, investors are underinvested in cyclical sectors, including financials, industrials, and energy; and in higher-beta regional markets including the eurozone, UK, Japan, and emerging markets.
Investors are skewed defensively
Investor asset allocation is noticeably tilted away from cyclical sectors
Source: Bank of America Merrill Lynch Global Fund Manager Survey. This survey was taken between October 4 and 10, 2019. A total of 230 participants with US$620 billion in assets under management participated in the survey. Z-score is the relationship (measured in standard deviations, a measurement of the spread of a dataset relative to its average) of an individual value versus the average of a group of values.
Bearish sentiment and defensive positioning are evident in other indicators as well. Barron’s most recent Big Money Poll showed a 20-year low in bullish sentiment, and according to recent Morningstar reports, inflows to cash funds are higher than normal.2
Substantial misalignments can potentially fuel strong rallies in underinvested market segments. When returns in one area inflect, animal spirits take over. Investors often scramble to reallocate (or “cover” short positions) and get in on early performance runways. When positioning is so one-sided, rotations into under-owned areas often endure.
Overly defensive positioning is not the only positive signal for cyclicals. Risk assets3 are also likely enjoying tailwinds from early signs of bottoming in some global economic data, better-than-expected earnings, and from positive geopolitical developments, including reduced probability of a no-deal Brexit and progress in US-China trade talks.
- Defensive positioning and negative sentiment are contributing to strong returns for cyclicals and other low-beta sectors and regions.
- Barring a derailment of trade talks or other strongly negative global geopolitical news, we believe this “risk-on” rally could persist into 2020.
- Investors may want to consider neutralizing their defensive allocations and rotating exposure to cyclicals.
1 Beta is a measure of risk that indicates the price sensitivity of a security or a portfolio relative to a specified market index
2 Source: Morningstar.com. Cash funds have seen US$376 billion in flows year-to-date through 30 September 2019, compared with US$56 billion over the same months in 2018 and an average of US$53 billion for those period over the past 10 years.
3 Risk assets (such as equities, commodities, high-yield bonds, real estate, and currencies) have a significant degree of price volatility.
Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets or in a particular geographic region or country. • Fixed income security risks include credit, liquidity, call, duration, and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.