What’s behind the rally in equities this year

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An important consideration for equity positioning today is understanding what’s been behind the returns in equity markets so far this year.

One theory is that it’s a cyclical recovery in global growth — either actual or perceived to be actual by investors (the rebound in commodity prices reflects this). If this is true, then gains have come from cyclical stocks and the risk to the market is that confidence in the recovery turns out to be misplaced and markets sell off. An alternative explanation is that it’s investors hunting for yield, in which case the risk is that central banks pull back. If they don’t, then the hunt will continue and bond proxies — low volatility, dividend-yielding stocks and sectors — will continue to outperform.

In fact, both explanations are true but the timing has varied. The cyclical picture was the principal one from the market low in February and following the Brexit sell-off (see exhibit 9 below). However, the broader trend of the hunt for income has predominated throughout the year and is the one that is likely to persist, at least until the next shock.

Comparing returns since 11 February 2016 and year-to-date by geography, sector, style, size and factor shows that there are few differences in performance between the periods by geography, size, or style (see exhibits 1-8). But following the February low and post-Brexit, cyclical sectors outperformed defensive sectors, and the factors for low size and value outperformed dividend yield, quality and low volatility. The opposite is true year-to-date, however exhibit 9 highlights the rotation that occurred in February and in July. The outperformance of cyclicals has faded over the third week of August and I would expect defensive/low volatility dividend stocks to outperform from here.

Exhibit 1: Returns of the MSCI All Country World Index (ACWI) by region for the period from the equity market’s low on 11 February 2016 through 23 August 2016

Graph 1 DM rally

Exhibit 2: Returns by style and sector of the MSCI All Country World Index (ACWI) for the period from the equity market’s low on 11 February 2016 through 23 August 2016

graph 2 DM rally

Exhibit 3: Returns of the MSCI All Country World Index (ACWI) by style/size for the period from the equity market’s low on 11 February 2016 through 23 August 2016

graph 3 DM rally

Exhibit 4: Returns by investment factor of the MSCI All Country World Index (ACWI) for the period from the equity market’s low on 11 February 2016 through 23 August 2016

hh

Exhibit 5: Returns by region of the MSCI All Country World Index (ACWI) for the period from 1 January 2016 through 23 August 2016

graph 5 dm RALLY

Exhibit 6: Returns of the MSCI All Country World Index (ACWI) by style and sector for the period from 1 January 2016 through 23 August 2016

GRAPH 6 DM RALLY

Exhibit 7: Returns of the MSCI All Country World Index (ACWI) by size/ style for the period from 1 January 2016 through 23 August 2016

graph 7 DM rally

Exhibit 8: Returns by investment factor of the MSCI All Country World Index (ACWI) for the period from 1 January 2016 through 23 August 2016

graph 8 dm rally

Exhibit 9: Index returns for 2016 year-to-date (through 23/08/16) – Cyclical plays dominated from the market’s lows in February and in the period post-Brexit. The broader trend however has been the hunt for safe income. In my view, until the next shock, the hunt for safe income is likely to dominate.

graph 9 Dm rally

Sources: MSCI Barra, BNP Paribas Asset Management, as of 23 August 2016

The primary driver, of course, remains the central banks. While we all ask whether yields can go lower, exhibit 10 below suggests the answer is yes. Central banks own “only” 30% of the government bond market (US, UK, Japan and eurozone), and as QE isn’t likely to end anytime soon, the inexorable quest for yield remains.

Exhibit 10: How low can bond yields go ? How much more sovereign debt can central banks buy? Central bank purchases of government bonds looks set to continue for a while longer, and in my view, could even accelerate. If so, yields will only go lower and investors will keep searching for income, wherever they can find it.

graph 10 ddm

Sources: US Federal Reserve, European Central Bank, Bank of Japan, Bank of England, Barclays, BNP Paribas Asset Management as of July 2016 [divider] [/divider]

 This article was written by Daniel Morris, Senior Investment Strategist, on 24 August 2016 in London

Daniel Morris

Senior investment strategist, CFA charterholder

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