According to Wolf von Rotberg, equity strategist at J. Safra Sarasin Sustainable Asset Management, the recent rotation in global equities might have further to go as he shares in the following analysis
The rotation in global equity markets triggered by the surprisingly soft June CPI print has legs in our view. The disinflationary momentum which has re-established itself over the summer is set to pave the way to the first Fed rate cut. The knee-jerk reaction to the softer CPI data has been a surge in highly levered and beaten-up small cap indices as well as a sharp appreciation of the Japanese yen. Both those market segments had been the biggest victims of higher rates and are equivalently benefitting as a more disinflationary mindset is taking hold in markets. This will continue for somewhat longer, in our view, resulting in further small cap outperformance and Japanese equity underperformance. That said, we expect defensive sectors to outperform over the coming 3 to 6 months.
The past three weeks have been marked by a rotation in markets, which was broadly in line with the scenario we had positioned for. Even though it had been clear for some time that the uptick in US inflation in Q1 would not change the disinflationary trend, many pockets of the equity and FX market did not yet feel comfortable to price for a fading in inflationary pressures. This stood in contrast to the fixed income market, which had started to reprice more rapidly over recent months as it became clear that central bank targets were coming within reach. As the June CPI data showed 3-month changes of core prices falling to an annualised 2.1%, thereby moving closer to the Fed’s target, the perception changed in both equity and FX markets. US small caps have gained by around 8% since then, to levels last seen in January 2022, and the yen has risen by 5%.
As we have argued before, both these asset classes have been among the most exposed to higher rates, but have failed to benefit from the gradual grind lower in government bond yields over recent months. Small caps’ relationship to rates has shifted in recent years. While they were largely immune to rates moves in the pre-pandemic years, with their performance primarily following the cycle, the sharp uptick in yields on the back of higher inflation over the last two years changed this relationship. The market started to focus on corporate leverage and whether companies can afford it. As small caps are the most levered pocket of the equity market, in particular in the US, they took a significant hit when rates started to surge. It is not only debt levels, but also the structure of debt, which makes small caps particularly vulnerable. Around 30% of US small -cap debt is floating, which stands in stark contrast to large-cap firms, where floating rate debt is a rare feature. Another reason for small caps’ rates sensitivity is financials, including regional banks, which is the largest small-cap sector. Regional banks have underperformed substantially against the backdrop of rising rates as firstly, their large fixed income holdings took a big hit, leading to the demise of Silicon Valley Bank, and secondly, they lost deposits to higher-yielding money market funds as well as to larger banks. As rates are coming down, those pressures are not only fading, but inverting, providing a substantial lift to small caps.
The underlying drivers are the same for Japanese yen, but for different reasons. While other developed market central banks have been fighting rising inflation over the past two years, the BoJ remained largely inactive. The divergence in central bank policies led to a widening yield gap between Japanese yields, which rose only marginally, and sharply rising yields elsewhere. As a result, the yen turned into the global funding currency and dropped to the lowest level vs the USD in almost 40 years. US yields have become a key driver of the yen’s exchange rate, not only vs the USD but also on a trade-weighted basis (which is ~1/3 vs the USD). While the yen had initially not tracked the most recent drop in US yields, it has started to strengthen after the June CPI print and will likely continue to do so. Continued strength in the JPY would suggest further weakness for Japanese equities vs global equities, which is reason for us to remain cautious on the Japanese market. We also do not expect corporate governance reforms in Japan to have a material short -term impact and would stick to the guidance provided by the typical cyclical drivers of the market.
We would not hold this view on the currency and the Japanese equity market, if there was no scope for US yields to decline further. The primary reason for yields to come down has been the inflation picture over the past year. As mentioned above, recent prints are clearly pointing to inflation easing back to 2%, and looking ahead, this is unlikely to change. Underlying drivers are pointing to a further easing in inflation, which will likely provide continued relief to those segments of the market which have suffered the most from higher yields. The super-core services CPI measure, which excludes shelter, has tracked changes in the non-manufacturing ISM with a lag of roughly 12 months. Given that the non-manufacturing ISM has peaked in August 2023, and has been trending lower since, we would expect the downside pressure on super-core services inflation to be maintained in the months to come. The shelter component, which has been a headache for the Fed as it has remained well above 2% in recent months, should ease as well. Paradoxically, it should follow the recent decline in yields. In particular, owner-implied rents are positively correlated to yields. Higher financing costs require higher rent payments to compensate. Or put differently, if financing costs rise, potential homebuyers are incentivised to rent, thereby driving rents higher. Vice versa, if financing costs fall, rents have room to move lower, and this typically happens with a 6- to 9-month lag.
Against the backdrop of falling inflation, we think that small caps still have room to out-perform, extending their recent relative gains. Valuations remain depressed, even after the rebound, providing a buffer against softening earnings. Less attractive than small caps in the very short-term, but more attractive throughout a moderating cycle, are defensives, which we expect to outperform over the coming 3 to 6 months.
