Global Weekly: Is sector rotation coming?

News item -

It’s been an interesting week. Infection rates in the US rose rapidly, and states such as California introduced lockdown measures again. Stock markets went higher and Nasdaq reached a new all-time high on Monday. More importantly, as the US earnings season kicked-off, with the big US banks reporting their second-quarter results, investor interest switched from tech stocks towards more cyclical sectors, such as energy and industrials. Small-cap stocks also attracted more attention, with the Russell 2000 Index gaining more than 3% on Wednesday, hovering above its 200-day moving average. This is clearly something we are watching. It could be an indication of a more robust recovery and hence a potential sector rotation. But first, we want to see upcoming earnings and fundamental data.

Investment banks, including JPMorgan and Goldman Sachs, surprised positively, with better-than- expected results -- both top line and bottom line. On the other hand, banks with a more traditional business model, such as Wells Fargo, disappointed, as they had to impose much higher loan-loss provisions than expected. Furthermore, Wells Fargo shocked investors by announcing a dividend cut of 80%.

In the health care segment, UnitedHealth reported second-quarter results that beat average analyst estimates and, most importantly, maintained their full-year earnings outlook.

In Europe, chipmaker ASML reported a slight miss on earnings. But this time analysts were more interested in the company’s outlook and here ASML delivered. Its order book was strong, and there was a better-than-expected guidance for the third quarter.

Although the US earnings season had a promising start, we continue to be cautious. We expect second-round effects from the newly imposed lockdowns in several US states. For the time being, equities remain slightly out of favour (small underweight); we continue to prefer the information technology and health care sectors.

Bonds: Appetite for risk may be fading

The risk-on mood, responsible for one the biggest recoveries in financial markets, seems to be losing strength. There may be rising sentiment that the recovery in risky assets was too fast and decoupled from the real economy and politics, more specifically, the US trade policy against Europe and China.

In regards to our preferences in high-return bond segments, we remain positive regarding emerging-markets debt (EMD), given the risk of the covid-19 virus going slightly out of control again and destabilizing markets. We favour EMD because of the asset class’ composition of investment-grade debt, which should provide support in a risk-off mode, especially in comparison with high-yield bonds. We are also confident that the continuous inflows will compress spreads.

We haven’t made any bet yet on local currencies EMD, given the uncertainty at the moment. The recovery in China is not yet strong enough, and Asian currencies have been losing their latest gains. In Latin America, the covid-19 virus peak does not seem to have yet arrived, and there were new cases discovered in some US states. All of this does not support the sentiment that had pushed risky assets higher, although we are confident that the same strict lockdown measures will not return, which will help sustain the economy.

Regarding the high-quality bond segment, we believe Spanish government bonds might be stretched after a fruitful rally. While French government bonds have negative yields, they could provide safe-haven protection.