It’s hard to believe it’s been a year since Boris Johnson announced the first full national lockdown to tackle the Covid-19 pandemic.
By then, markets had already been through the fastest sell-off in history, falling some 25-30% in three weeks. Who would’ve thought then that 2020 would turn out to be a strong year for equities? The rest of 2020 saw many column inches taken up by talk about potential shapes of recovery and, as we move through 2021 there seems to be a consensus that things are improving.
Like most of the last decade, last year was the year of growth stocks, with the likes of technology, e-commerce and the wider consumer sector leading the way across developed and emerging markets. However, we started to see a value rally in the last part of the year, as positive news on vaccines boosted confidence.
Will volatility fall in the coming months?
I think we are now at an interesting point in markets – in particular because we are approaching an economic restart, not an economic recovery due to Covid being more of a natural than economic disaster. This is why the arguments over inflation are interesting. Covid has caused demand and supply to fall rapidly across the globe – in a normal recession it is only the former which falls. Should economies open up quickly, the big challenge for companies will be to meet the sharp rise in demand for their products and services.
I recently read an article from Blackrock which says that although the Vix index currently sits well above its long-term average, an improving economy and exceptionally easy monetary conditions should see this fall in the coming months. It goes on to add that while lower volatility suggests greater equity gains, those gains may not be shared equally, with cyclical/defensive companies likely to come to the fore*.
Blackrock says that based on 20 years of data, when the Vix is falling the MSCI Cyclical – Defensive Return Spread Index posts an average monthly gain of around 1%. When there is a significant fall in volatility of 10% or more, average cyclical outperformance expands to nearly 2%*.
I believe cyclical parts of the market like leisure, travel and gyms should pick up regardless of inflation – although it should be pointed out it will come from very low levels. There will be a surge in people going out and booking restaurants and it is hard to imagine there will not be some increase in consumer spending to counteract the past 12 months.
Not all cyclicals are the same
The important point is not all cyclicals are the same and there will be consolidation across sectors. Airlines are a good example. There will be consolidation, but you’d expect the likes of Ryanair and Easyjet to be the beneficiaries, giving them pricing power and greater market share. As you’d expect, this is where active management will help – particularly as cyclicals and defensives are more than just a value play.
Another example would be the industrial manufacturing sector in the UK. Even ahead of a re-opening of the economy the CIPS/Markit manufacturing purchasing managers’ index stood at 54.1 for January 2021 (anything above 50 implies growth). By contrast, the equivalent reading for the services sector was below 40 in January**.
Ways to play the recovery
There are a few ways to invest in this trend, the first of which is value. A good starting point is the Schroder Global Recovery fund, managed by Nick Kirrage and Andrew Lyddon, which has an overweight to the likes of financials and energy***. The UK also has a tilt towards value investing within its index, and investors can tap into this through a pure value play like the ES R&M UK Recovery or the Jupiter UK Special Situations funds. Equity income funds are also exposed to these types of defensive plays with Artemis Income and the City of London Investment Trust both good core options worth considering.
The final area is Europe, which has a typically higher exposure to cyclicals than other parts of the globe. I’d also highlight that healthcare, consumer staples, industrials and consumer discretionary companies now account for more than 50% of the MSCI Europe – giving the index more of a balance than it has had previously due to a larger exposure to financials****.
The likely re-introduction of dividends in the banking and insurance sectors also add to the attraction for Europe. One worth considering here would be the Blackrock Continental European Income fund.
Darius McDermott is managing director at Chelsea Financial Services
*Source: Blackrock: As volatility fades, can cyclicals shine?
**Source: Schroders: How can investors access the UK’s industrial recovery?
***Source: fund factsheet, 31 January 2021
****Source: Schroders, FactSet, MSCI Index figures, 30 June 2020
