The impact of rate cut optimism

Image of Bank of England

This column has noted before (10 April 2019) the apparent disconnect between what bond markets and equity markets are saying. The renewed collapse in bond yields would appear to be presaging an economic slowdown, or even a recession, yet equity markets seem buoyant as analysts continue to predict an acceleration in earnings growth from the second half of this year onwards – perhaps egged on by corporate management teams who are propagating such a message.

“The renewed collapse in bond yields would appear to be presaging an economic slowdown or even a recession, yet equity markets seem buoyant.”

Having just attended a meeting with a highly-respected bond fund manager who noted that he had not been as bearish as he is now since 2008, it may be again worth checking to see just what equity markets are saying and believing. And this time around, rather than looking at just the headline equity benchmarks and the volatility index (or ‘VIX’), we shall dig a bit deeper and analyse equity sector performance.

Some 39 individual sectors make up the FTSE All-Share, and the list of the best and worst 10 performers in the year to date is unlikely to shock clients and advisers too much.

The predominance of cyclicals such as Industrial Metals, Electricals and Electronics, and Industrial Engineering in the top 10 makes sense given what seems to be the optimism that still pervades equity markets. By the same token, then, presence of stodgy defensives such as Utilities, Telecoms and Tobacco in the bottom 10 makes sense in the context of 2019’s rally in UK (and global) equities, and therefore may tally with the view that economic and corporate earnings are going to pick up pace in the second half of 2019 and beyond.

Strong showing from cyclicals and weak showing from defensives points to bullish tone to equity markets

Source: Refinitiv data

And yet it may not be quite as simple as that. Nestled among the best performers are Beverages, Food Producers, and Personal Goods – areas better known for being ‘Steady Eddies’ than go-go growth areas – whilst the list of laggards includes Travel and Leisure, Industrial Transportation, and Automobiles and Parts – all areas that are economically-sensitive.

Change of gear

The picture from quarter to quarter is also less straightforward than it might seem, once advisers and clients take a look at what did best in the first three months of the year and what has done best (and worst since).

At the end of March, Industrial Metals and General Retailers were in the vanguard, both cyclicals, while the tail-end Charlies included Healthcare and Telecoms, all purported defensives (or certainly areas seen to lack any exciting growth potential).

Yet a quick look at which sectors have advanced most up the rankings (with 1 seen as the best and 39 the worst) and those that have fallen the most, on a relative performance basis, may again suggest that confidence in the growth and economic outlook is not all that it seems.

Big gainers include Healthcare Equipment, Personal Goods and Beverages, who all rose in the rankings by at least nine spots. Losers included Mining, the house-builder-laden Household Goods grouping, General Retailers, and also Oil Equipment, where oil’s latest slide could reflect global growth concerns.

Defensive areas have put on a better showing in the second quarter

Source: Refinitiv data

Notable sliders

Two trends that are worthy of note concern Industrial Transportation and Banks. Both are bellwether sectors for the economy and neither is covering themselves in glory.

“Both Industrial Transportation and Banks are bellwether sectors for the economy and neither is covering themselves in glory.”

Banks and Transport stocks are weak in the UK …

Source: Refinitiv data

Nor is this confined to the UK: America’s Dow Jones Industrial Transportation index looks to be running low on gas and Banks are sagging globally, even though analysts are now saying that interest-rate cuts will be good for them, having spent the last 12 months arguing that hikes to borrowing costs would be helpful for their lending margins.

Both of those views cannot be right, but such cross-currents may in fact suggest that bond markets and stock markets are thinking along the same lines after all.

“Such cross-currents may in fact suggest that bond markets and stock markets are thinking along the same lines after all.”

Bond markets are anticipating interest-rate cuts from central banks, with extra-cheap credit for the banks in Europe and maybe even more Quantitative Easing down the road if the global economy really does hit the buffers.

Stocks are also responding to the prospect of further monetary stimulus, in the view that a further reduction in returns on cash and yields on bonds (in nominal and real terms) will drive advisers and clients toward equities once more. This view of the world – which can be summarised when it comes to equities in a low-interest-rate world as TINA: There Is No Alternative – has prevailed pretty much since 2009.

But advisers and clients might also care to remember that frantic central bank interest-rate cuts did not support stock markets during the 2000–2003 and 2007–2009 economic downturns, when growth and corporate earnings disappointed to such a degree that equity valuations simply could not be maintained. Those clamouring for central bank action should perhaps be careful with regard to precisely what they are wishing for in the coming weeks and months.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.