(Bloomberg) — Equity investors have been building their defenses for months. Now the bulwark is being dismantled in a rapid rotation out of winning haven trades and into riskier plays.
Thank the prospect of a U.S.-China deal and improving economic data. Bond yields are jumping again, debt-like equities are down, and volatile stocks from small-caps to cyclical companies are back in favor.
It’s all a big change in tone from the wariness that marked most of the S&P 500’s advance this year, during which many investors clung to downside protection. That caution left defensive trades extended, setting the stage for the rally to continue — especially if America and China finally put pen to paper on a phase-one deal.
“The market’s expectations for a U.S.-China trade agreement are becoming stronger with each passing day, and many investors seem to have come to the conclusion that they have no choice but to take on more risk,” Masanari Takada, a strategist at Nomura Holdings Inc., wrote in a note.
A glance at the various stock characteristics — or factors — that drive many quantitative trading strategies shows how extreme the rotation has been.
The value strategy of buying cheap stocks has staged a comeback, beating typically expensive shares with high growth prospects. The former also tends to do better when the yield curve is steepening, in part because that signals a brighter economic outlook favoring the more cyclically oriented value cohort.
The momentum strategy of buying the past year’s winners — in this case, defensive stocks — on Monday plunged the most since the factor quake in early September.
Sanford C. Bernstein upgraded the value factor in the U.S. and Europe while remaining bearish on momentum on Tuesday. The strategists cited improving earnings revisions and inflows into global equities among other reasons, though they stressed it was a tactical rather than a longer-term call.
“Although fundamental hedge funds have lowered their momentum exposure, they can still drop it further,” the team led by Inigo Fraser Jenkins wrote in a note. “We have yet to see meaningful rotation to value, so the trade is by no means ‘done’ after the September move.”
Low-volatility shares, which tend to be filled with stodgy sectors less exposed to the economic cycle, have started to underperform after beating the market for years.
Equity gains for much of 2019 had been fueled by stable, large companies, but a new exuberance is starting to spread. In the U.S., small-caps are at last gaining some ground versus the corporate giants which have dominated for so long.
A brighter outlook for international commerce could also rupture America First trades. Emerging-market shares are starting to gain ground versus American equities amid optimism that easing tensions will lift economic growth in trade-sensitive countries such as China.
In a sign of improving sentiment, the yuan on Tuesday strengthened past 7 per dollar for the first time since August — a fillip for global cyclical trades.
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