Sector Rotation: Finding the Market Leaders Written by Deon Botha and Donald Curtayne, Equity Analysts at Fairtree Capital

Transcription

1 FUNDS ON FRIDAY b y G l a c i e r R e s e a r c h Sector Rotation: Finding the Market Leaders Written by Deon Botha and Donald Curtayne, Equity Analysts at Fairtree Capital 09 D e c ember V o l u m e Macroeconomic factors such as interest rates, currencies and economic growth can have a significant influence on the profitability of a company over the medium term. As companies in the same industry often have a comparable exposure to these economic variables, the equity returns of these companies have a tendency to move in a similar pattern. A sector rotation strategy proposes that an investor can generate a return above that of the market by taking advantage of the fact that specific industries will outperform others depending on the current and future stages of the economic cycle. The Business Cycle F U N D S O N F R I D A Y 0 9 D e c e m b e r Page 1

2 While each business cycle is different in length and susceptible to macroeconomic shocks, the progression of activity in an economy has shown a propensity to follow a repeating cyclical pattern which we have simplified into three distinct phases: Recovery Phase: where an economy exits a recession and economic activity begins to pick up. This phase is generally characterised by rapidly improving growth, relatively low inflation and accommodative monetary policy. Expansionary Phase: generally the longest phase and itself composed of its own distinct stages, is characterised by a growing economy with strong credit extension, increasing inflationary pressure and a corresponding tightening of monetary policy. Contraction Phase: Eventually an economy which is stretched, facing high inflation and restrictive monetary policy begins to contract, pulling the economy into a recession. The recessionary environment is characterised by low levels of economic activity and negative growth. This results in low inflation and an easing of monetary policy. Positioning for the Phase Financial assets which are sensitive to the business cycle, which includes most equities, tend to perform well in an expanding economy with a relatively accommodative monetary policy such as in the recovery phase and early in the expansionary phase. They then moderate in the later stages of the expansion before going into decline during a recession. The performance is inconsistent however, with sectors having varying exposures and sensitivities to inflation, interest rates and economic activity. Determining this exposure is complicated further by the global nature of markets. This is particularly pertinent for a South African investor as the JSE includes a number of companies which are exposed to economic variables outside the country. Numerous JSE listed companies export their product or operate primarily offshore. Furthermore, South African resource companies are geared to the performance of commodity prices which are driven by the global economic outlook in general and Chinese economic activity in particular. For this reason, one must consider the exposure of each sector and company on the JSE to consider how it may respond to the macroeconomic environment and the relevant business cycles it faces. The early stages of an expansion are a boon for most companies in that economy, but it is those companies which are disproportionately affected by increased economic activity or are sensitive to interest rates and increased borrowing that have tended to outperform. This includes sectors such as discretionary consumer goods, including clothing retail, and general industrials. In addition, a brighter outlook for global demand results in an improved outlook for commodity companies. Page 2

3 As the expansion matures, the sectors that are most exposed to robust economic activity, moderate inflation and improved credit availability have generally fared well. This environment lends itself to improving business and consumer confidence which are in turn indicators of an increased likelihood of capital investment. Financial services, such as banks and insurers tend to do well during this period, as do capital goods producers - such as construction and resources. As inflationary pressure builds in the later stages of the expansion, those sectors which are exposed to raw materials, such as mining, basic industries and energy have outperformed. During a contractionary environment, those sectors where consumers are less likely to make significant cutbacks to expenditure are expected to do well. This includes telecommunications, consumer staples (such as food production and retail) and healthcare. High dividend yielding sectors are often somewhat protected from the sell-off in a recession. Current position on the cycle It is important to keep in mind that each cycle is different in its progression, length and characteristics. Further, a cycle is always vulnerable to shocks economic and political. This uncertainty is currently particularly pertinent when one considers that 2017 will see a new president in the United States, the National Congress of the Communist Party of China, elections across Europe, as well as the ANC s National Conference. An investor must therefore take special care in interpreting the business cycle and forecasting the macroeconomic outlook. Page 3

4 South Africa has been experiencing tepid economic growth of late. The Reserve Bank s Monetary Policy Committee is forecasting 2016 GDP growth of 0.4%. This has coincided with low consumer and business confidence and inflation rates above the stated target band. The outlook on this front is somewhat more constructive though, with expectations of a moderation in inflation thanks to the abatement of the El Nino induced drought which pushed up the prices of soft commodities as well as a strengthening of the rand. Stronger commodity prices, a normalisation in inflation and a halt to the rate hiking cycle (with some possibility of easing) may bolster the South African economy. While strong economic activity is not currently forecasted, the current outlook is for a somewhat normalised situation. The world s largest economy, the USA, has experienced a very drawn-out recovery from the 2008 financial crisis. This recovery has been characterised by low economic growth, low inflation, and extraordinary levels of monetary easing. Quantitative easing has subsequently come to an end, and 10 year treasury yields are trending upwards. In addition, GDP growth is now looking more robust, with the economy expanding at 3.2% in the 3rd quarter of 2016 and inflation approaching the 2% target. The US therefore seems to be, finally, exiting the recovery phase and entering a more normalised expansion tied with an acceleration of inflationary pressures. The world s largest consumer of resources, China, has had an economy characterised by significant volatility and widespread intervention. While GDP growth has trended down over the last decade, growth remains very strong at 6.7% GDP growth, inflation remains subdued and monetary policy is accommodative although credit extension remains subject to regular adjustments to policy. With the National Congress of the Communist party taking place in the coming year, the government is expected to be focused on ensuring social stability and continued growth. While the cyclical inflections are near impossible to predict, we believe prudent investors should take notice of the above-mentioned dynamics at play in the regional drivers of the JSE. Prudent investors could look to real assets that can keep up with global inflation and rethink allocations to instruments that have fixed coupon payments. The prospects of the South African economy and the many political risks in the year to come will make for some new debate about the long-term competiveness of the SA economy. Determining what is cyclical and what is structural will be the demanding differentiator for market participants in the year to come. Similarly, distinguishing what China s resource thirst will grow at structurally and at different points of the cycle will help investors decide when to invest in this sector. Page 4

5 In our view, a sector rotation investment strategy offers great insight into how investors could position portfolios at certain times to outperform the market, but recognising that South Africa has more than one cycle is essential. Recognising the different cycles and stages of development is key to the prudent and successful application of this strategy. With this knowledge, investors can manage risks and opportunities across sectors and cycles to create well-diversified portfolios that deliver attractive riskadjusted returns. Glacier Research would like to thank Deon Botha and Donald Curtayne for their contribution to this week s Funds on Friday. Deon Botha, M Comm (Econ), CFA II candidate Deon joined Fairtree s equity research team in June 2013 as a generalist. He studied at the University of Stellenbosch where he completed his Masters in Economics. Deon kicked off his career in the Leverage finance division of IKB in Frankfurt, Germany. Upon a short stint in corporate finance with Merit Capital, he joined Fairtree to pursue his passion in Financial Markets. His current duties include analysis across industrials, financials, telecommunications, paper, chemical and oil sectors. Donald Curtayne, CA (SA), Passed CFA Level III Donald started at Fairtree in July 2016 as a general equity analyst. He studied Finance & Accounting at the University of Cape Town and subsequently completed his Chartered Accountancy training contract at KPMG in Johannesburg. After a brief audit assignment in the United States and completing the final CFA exam, he joined Fairtree's equity research team. His current coverage includes JSE listed food producers, miners and non-cyclical midcaps. Page 5