Equity markets have demonstrated the most enthusiasm for rotation. Prior losers, such as the FTSE 100 and Stoxx Europe 600 have surged ahead versus the S&P 500 where leading sectors such as information technology and consumer discretionary have given way to more cyclical sectors such as industrials and materials. Financials and consumer staples have also improved notably over the last month, transitioning from market laggards, to near market leaders.  

We’ve taken a number of steps over the last week to participate in this developing narrative by reducing exposure to the quality factor and increasing exposure to US industrials which stand to benefit from increased infrastructure spending in the aftermath of the US election. Since inception the trade has posted positive relative returns.

In last week’s blog, I suggested that for the rotation to have legs we would need to see higher bond yields. However, bond markets seem far from convinced.

In fact, long-dated Treasuries, which originally sold-off, promptly reversed course and have since rallied back above upper resistance in yellow. This pause in the trend towards a steeper yield curve can be explained by short term factors and I retain my forecast for a steeper yield curve in 2021. These factors include the surge in new coronavirus cases, increased likelihood of lockdown (hitting GDP numbers in Q4) and the diminished likelihood of a new fiscal package before the Georgia senate run-off in early January.   

It was a similar story for high yield bonds which declined to follow US small caps higher, despite their cosy and long-established correlation.

An old wall street saying asserts that the bond market is smarter than the stock market. If that’s true, it might prove prudent to exercise some caution, which is why I’d rather ease into the rotation trade, at the expense of short-term underperformance, than go all-in. That said, if its conviction we’re looking for, we might be looking in the wrong place.

When we talk about the US dollar, it’s usually in reference to the dollar index, which represents a basket of developed market currencies, dominated by the euro (which makes up over half the index weight). At the time of writing this index is at key technical support, flirting with its weakest level since April 2018. Should the dollar break through this level it could catalyse the next leg of the ongoing rotation trade.

There has also been clear US dollar weakness against Asian currencies, as demonstrated by the Bloomberg JP Morgan Asia Dollar index which has risen to its highest level since June 2018. This is due to a variety of factors including better containment of the virus and a strong economic rebound across the region, led by China.

In The Call-Up, published late September, I wrote:

“depending on the progression of the virus, we remain open to the possibility of a broader economic recovery, improvement in risk sentiment and subsequent rotation into cyclical investment opportunities. Such opportunities exist within the broader emerging market currency index which continues to lag developed market peers… by around 15% versus the US dollar”.

Since then we have seen a notable rally across emerging market currencies (a fall in the redline represents stronger EM and a weaker US dollar) even as the developed market US dollar index has gone sideways. What I find particularly interesting is the initial catalyst for this move was not news of a vaccine, but the US election. This is consistent with the prevailing view that a Joe Biden victory is good for EMs, primarily through global trade growth which should improve relative to Trump’s more protectionist stance.

The portfolios have benefited from this over the last few months given our overweight allocation to emerging market currencies with unhedged exposure to the Chinese renminbi, South Korean won and Taiwanese dollar.

However, recent gains have increasingly been driven by non-Asian currencies such as the Brazilian real, Mexican peso and South African rand. This rotation, towards EM value, is consistent with what we are seeing in developed market equities and my belief that we will see a strong cyclical recovery across emerging markets in 2021. Key drivers include rising support from external demand (driven by a widening US current account deficit, low US real yields and a weaker dollar) as well as China’s reflationary growth impulse and the lagged effects of prior accommodative domestic policies.

The prevailing narrative is China, first and foremost, and East Asia more generally, has come through the pandemic far better, both medically and economically, than other regions. Meanwhile, there is a second group of EM countries which have suffered far more, in both regards, and their markets have suffered accordingly. The conundrum is whilst East Asia is driving the recovery, and may continue to do so for some time, asset valuations are far higher relative to economically sensitive EM value stocks which look especially cheap and could outperform if a vaccine proves effective. EM economic growth is already showing signs of gaining momentum and EM ex China has the greatest potential to catch-up with the rest of the pack. From a vaccine perspective, the game changer for these countries wasn’t Pfizer/BioNTech or Moderna but Monday’s announcement from Oxford University / AstraZenca – whose vaccine is more conventional, easily storable and cost effective, with an admirable efficacy rate.

Within EM value, undervalued commodity currencies, such as the Brazilian real, stand to benefit from a pick-up in commodity prices driven by ongoing US dollar weakness.

Another notable opportunity is Russia, which has seen the rouble flounder against the US dollar whilst other currencies have strengthened. This can be explained by escalating coronavirus infections and the currency’s high correlation to oil prices. It is my belief that ongoing steps towards an eventual vaccine could end that underperformance, particularly if energy prices start to participate in the commodity rally. The Russian equity market is a true EM value play via its high exposure to natural resource companies like Lukoil and Norilsk Nickel, and financials, like Sberbank, which benefits from a steeper yield curve compared to mature economies.

Finally, a few words on Brexit, given the US dollar has fallen to 1.33 against the UK pound. Whilst no-deal remains a clear risk, the UK seems to be moving ever closer to some kind of a deal as signalled by the recent break above the 6-year resistance line in yellow. If a deal is achieved, we could see the currency rally towards its long-term moving average in the mid-1.50s by the end of 2021.