Quantitative Easing

RBA June 2022 Outlook

Bear markets signal a change in leadership

Bear markets always signal a change in leadership within the overall stock market. Incoming leadership in a bear market is rarely, if ever, outgoing leadership. Because of this rule of thumb, we view bear markets as times of extreme opportunity. In our view, this cycle has been no different so far: leadership seems to be changing as the current bear market progresses. (See graph 1)

Bear markets occur when the economy structurally changes. Leadership before a bear market is usually focused on the prevailing economy, but leadership changes as the economy evolves. Volatility occurs when previous leadership suited to a pre-existing economy gives way to new leadership better suited to a new economic context.

The economy is constantly changing and markets are adapting to these changes. History clearly shows that it is unrealistic to expect one segment of the equity market to fit every economic scenario.

However, despite historical precedents, investors are generally reluctant to reposition their portfolios when the economy changes. They tend to cling to old leadership hoping that the underperformance of these stocks is only temporary and that the economy and markets will recover soon.

The current market volatility is not unique. Rather, it appears to reflect a significant shift in the economy that is reflected in sector returns. The global economy is going through major structural changes that seem likely to alter the secular trend of inflation and interest rates. It makes sense that new leaders better suited to new secular trends are emerging.

The former leadership, which is now performing significantly worse, was focused on secular disinflation and lower long-term interest rates. The performance of so-called long-term equity themes like technology, innovation, disruption, etc., was based on lower long-term interest rates. Their outperformance reached true extremes when the Fed’s quantitative easing (QE) program further lowered long-term interest rates.

Figures 2 and 3 highlight leadership changes. Chart 2 shows the performance of the sector for the 3 years preceding the market peak, while Chart 3 shows the performance of the sector from the peak.

US inflation hit 40-year highs and sector performance highlighted inflation-friendly sectors such as energy and materials. Defensive sectors, which tend to follow inflation-oriented sectors at the end of the cycle in a normal cyclical rotation, were also among the leaders (see graph 2).

However, the sectors that have benefited the most from secular disinflation and falling interest rates (technology, communications and consumer discretionary) are the worst performing sectors since the onset of volatility.
Chart-2

Chart-3Two recent past examples

Some believe that the current period of market volatility and shifts in industry leadership are unique or temporary. Recent history shows that neither is true. Charts 4 and 5 look at the sector’s performance over the 3 years before the peak of the tech bubble and the 3 years after. Charts 6 and 7 look at sector performance around the bursting of the financial bubble.

Chart-4

Chart-5

Chart-6

Chart-7Don’t cling to the past. The economy is constantly changing and evolving.

It is natural for investors to fear the unknown, however, how much of an insurance policy should one pay for uncertainty and fear? So far in this cycle, it looks like comfort is costing around 25%, i.e. investors have given up around 25% return to hold on to the old stories.

The US and global economies have always changed over time and continue to do so. It seems very unrealistic to assume that one industry or market segment is appropriate for every economic environment. Long-term equity segments such as technology, innovation, disruption and venture capital were the right themes for secular disinflation and falling interest rates, but other sectors seem better suited to developments in the global economy.

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