Investment professionals have many different methods for slicing up the investment world. Typically, we tend to group assets together in terms of region, asset class or sector. Looking at things sector by sector is helpful for judging what to overweight and when, since different industries will react differently to underlying economic conditions (for example, technology or ‘growth’ companies tend to do well early in the economic cycle, and not as well later on), but breaking down the entire global economy by sectors can be misleading. In our globalised world, industries’ progress across different regions is often correlated, but nations’ diverging economic backdrops means this is not always the case.
The financial sector is a good example. In the US, the financial sector is largely driven by investment banking revenues – which ties bank profits closely to capital markets. Likewise, corporate financing in the US is often conducted through corporate bond markets rather than traditional bank loans. This is a different set-up to Europe, where large investment banks are sparse and traditional banking is much more prevalent. In line with this, European firms often get their finance through the usual banking routes. These disparities can lead to vastly different sector performances: This week, JPMorgan, Morgan Stanley and Goldman Sachs all comfortably beat earnings expectations for the last quarter – significantly boosting US financials.
The US and Europe also differ in their materials sectors. US construction only makes up 4% of the US materials sector, while in Europe it is 11%. The US sector is instead heavily dominated by chemical producers, which account for almost half of the overall index. Contrast this with the UK, where metals and mining industries tend to dominate, and we see that the fortunes of companies that happen to be listed together are often not that closely correlated.
These regional differences have attracted the most attention in the technology sector, which has long been the superstar of stock markets. Huge amounts of capital has flowed into the sector in recent years, but a disproportionate amount has gone to the mega-caps in Silicon Valley. Indeed, a trend that has generated much attention throughout the current crisis is that US tech companies – despite being already at extended (i.e risky) valuation levels – seem to have achieved a ‘safe haven’ status. They are now not just seen as growth engines, but as reliable earnings providers. We should note, however, that some of the stocks that have benefitted the most from governments’ “stay at home” orders are, in fact, classified in the non-tech sector: Amazon is classed as a consumer discretionary company, while Google and Facebook are listed as communication firms.
This week, we have noticed an interesting change. Investors have rotated away from the big lockdown winners towards some previously unloved sectors. Laggards like energy and industrials have found some buyers – in line with their better-than-expected recent earnings reports. The chart below shows some of the biggest surprises from the recent earnings season, including industrials and financials.
We see this rotation away from the previous superstars as a healthy development. While the US tech mega-caps undoubtedly have much to offer investors, in recent months many have reached valuations (price over earnings) and market cap levels which look hard to justify. A rebalancing of capital towards other parts of the economy is therefore a welcome development.
Blog by Tatton Investment Management Limited