Given the prospect of an interest rate hike by the Fed and of reflation, partly driven by higher oil prices, long-term rates rallied; this sustained and amplified the sector rotation that had already begun in September.
Towards an amplified sector rotation?
The shift was all the more spectacular as it happened at a time when flows into equity markets were negative; investors therefore had to sell high quality defensive holdings – proxy fixed income stocks sensitive to long-term yields – to finance the purchase of financial, oil, cyclical and low-quality stocks.
Against this backdrop, the 1.2% performance recorded by the Euro Stoxx TR* index hides significant discrepancies
Against this backdrop, the 1.2% performance recorded by the Euro Stoxx TR* index hides significant discrepancies: on the one hand, cyclical stocks, and financial and oil stocks in particular (sectors that have rallied 8.2% and 3.9% respectively during the month) outperformed, while on the other, defensive stocks – such as agribusiness or healthcare (down -1.7% during the month) severely underperformed. Concerns over potential downside pressure on drug prices if Hillary Clinton is elected continued to fuel volatility and encouraged investors to take a wait-and-see approach on the healthcare sector, as it has been the case for several months now.
Sector performances from 10/01 to 10/31/2016
Caution on Q3 earnings publications
This pattern was also reflected in the market’s reaction to the first Q3 earnings publications: the slightest disappointments on quality, defensive stocks were severely sanctioned. For instance, Essilor lost 10.8% during the month following the release of mildly disappointing organic growth, although the company’s targets for its overall growth and margins were unaffected.
A favorable macroeconomic environment?
Admittedly, these factors – the prospect of an interest rate hike by the Fed, the Bank of Japan’s intention to steepen its yield curve, rumours that the ECB would lower its monthly asset purchases – could persist in the near term, feeding a sector rotation that would favour cyclical and financial stocks at the expense of more defensive names. However we believe that this recent move is excessive and that the conditions are not all present for the trend to be sustainable.
First, the macroeconomic environment is rather fragile and does not seem able to support a considerable rebound for corporate earnings growth within cyclical industries. We believe that we have entered a durable low growth and low interest rate environment, driven by the persistence of several factors that are weighing on economic growth and creating deflationary pressure: the accumulation of public and private debt over the past few years, a major demographic transition (ageing population) and disruptive technology (digitalisation).
Structural pressures on financial holdings and oil
The financial sector remains impacted by increasingly strict regulation, under-funding issues (particularly in Italy) and specific problems that nevertheless carry potential systemic risk (Deutsche Bank). Finally, although oil prices have rebounded, the OPEC countries’ agreement on restricting production seems both fragile and limited in time. In the United States, many oil wells that were not profitable are now resuming production at current prices, which will hold back any further potential upside for crude oil prices.
As we are in no way able to estimate the length or the intensity of this trend in the short-term, our approach remains cautious and focused on the key characteristics of our investment philosophy, namely valuations and the quality of fundamentals.
*TR: Total return. Perfomances as of 10.31.2016. Past performance is not a reliable guide to future returns and is not consistent over time.