One week / one topic: Rotation, rotation, rotation

What happened?

On Thursday, we witnessed the biggest one-day outperformance of US small cap stocks vs Mega Tech since January 2021.

The move immediately followed lower-than-expected inflation data and is very suggestive of position reduction within the hedge fund community, who had been capitalizing on the enormous outperformance between the two. (64% since January 2023)

As we know, the dominance of AI stocks has been predicated on the technology’s mesmerizing promise to transform companies, industries and societies.

While AI’s ‘killer application’ has not emerged yet, Tech giants remain set to spend over $1tn on capex in coming years – and investors (for now) have given them the benefit of the doubt.

The price move is perhaps even more important then, in the context of the incipient earnings season, as investors are expecting the rest of the market to catch up vs the recent dominance of Mag 7 stocks.

Looking into commentary from recent earnings calls, importantly, the starting point is also one where concerns about recession, inflation or supply chain shortages have been meaningfully subsiding.

Putting it all together, should we then interpret recent moves as the potential beginning of a new phase?

Are conditions ripe for the beginning of a meaningful rotation within equities, with the rest of the market perhaps (finally) taking the baton from Mag 7 stocks?

Our observations

• Fundamentals: In aggregate, corporates have responded well to the dual shocks of Covid and the subsequent sharp rise in inflation. Perhaps resilient growth and much-taunted rate cuts can set the stage for a widening of the rally and protracted equities strength?

• Price action: The day after such a move, 90% of S&P 500 stocks rose – with Tech megacaps rebounding as smaller firms kept climbing. New all-time highs beckon as realized volatility remains very low.

• Investor beliefs: Investors are pricing the dawn of a new ‘AI era’. As widespread adoption and profitability are not here yet, a ‘catch up’ in earnings growth could propel other sectors into the spotlight for a sharp reversal in relative performance.

So what?

Tech stocks have strongly outperformed since the global financial crisis of 2008, and again over the past 18 months.

Technological advancement has often been a game-changer through history, and indeed it can profoundly reshape the economy.

As an example, 60% of workers today are employed in occupations that did not exist in 1940 and technology-driven innovation accounts for 85% of employment growth over the last 80 years.

However, this is not all that matters for investors and there have been meaningful bouts of outperformance in other sectors – for example, Energy in 2021/22 – and indeed we aim to capitalize on such opportunities.

While we remain broadly positioned for a continuation of recent strong equities performance – while also being overweight Chinese equities since January – we are increasingly exploring sector-based opportunities across portfolios.

In particular, Industrials and Materials have registered recent underperformance and stand out as potential targets. (z-score of rolling 3-month performance differential vs MSCI World)