Bank of America Merrill Lynch calculated it “was the most aggressive rotation out of growth stocks in the past six years”.
Many high momentum growth sectors, including biotech and social networking, suffered large falls in excess of 10 per cent. This rotation then morphed into a size bias correction, with the UK mid-250 companies down 7.27 per cent, while the top 100 UK companies were up 1.78 per cent from February 28 to May 19. In the US, the Russell 2000 index was down 8.41 per cent, while the S&P 500 index was up 1.21 per cent from March 4 to May 21.
The trigger for this activity is not precisely known, but it is usually a marker of investors’ anticipation of a significant change in macro conditions. It is no coincidence that we have seen a number of speeches by central bankers that support such a view.
Mark Carney, governor of the Bank of England, recently noted in his Mansion House speech that the first rate hike “could happen sooner than markets currently expect”.
Meanwhile, James Bullard, Federal Reserve Bank of St Louis president, stated in June: “If you get 3 per cent growth for the rest of this year… if you continue to have jobs growth at 200,000, if you continue to see inflation moving back up towards target, I think if we get to the fall of the year and all of those things are transpiring… there will be more sentiment towards an earlier rate hike.”
While many of the areas that corrected have now bounced from the lows, most fund managers will be questioning if the bounce is sustainable or if small-, mid-cap and growth stocks will continue to underperform.
This is a complex and finely balanced point, but in the UK the suspicion is that, at minimum, the summer will be a tricky and relatively unrewarding period for UK mid- and smaller-sized companies, as investors factor in to their decisions the improving growth outlook and the unsettling prospect of rate rises.
Ned Davis Research helpfully points out that “while anticipating a rising rate environment, stock pickers tend to favour companies with greater cash holdings, lower financial leverage, and stronger dividend growth. Income-oriented investors shift their focus to dividend growth, instead of yield, as interest rates rise.”
In our opinion, the US is less likely to see such a marked underperformance at the mid- and small-sized companies level, although dividend growth stocks are likely to dominate. Investors appear to be extrapolating the current Q2 growth improvement into the second half of the year, although we believe that the rate of change is likely to fade.
US GDP growth is unlikely to match the Federal Reserve’s current 2.8 per cent forecast for 2014. Instead, we expect the Fed may lower growth expectations at the June meeting and offer some softer language on rate expectations.
If we are correct, yields on US bonds are likely to remain closer to their lows and this will continue to encourage equity investors into yield- and dividend-growth stocks.
In spite of developed markets reaching new highs, under the surface there have been some very large and testing rotations that provoke evaluation of which style bias will best reward for the remainder of 2014.
Mark Harris is head of multi-asset at City Financial
