Still Comfortable Being Uncomfortable

Equity markets continue to fascinate and surprise, with the one constant being a backdrop of uncertainty, driven by a cycle that keeps defying “the rules.”

Expectations of reflation and recovery, spurred on by U.S. tax cuts in 2018, quickly faded into a gloom of anticipated recession by mid‑2019, creating extreme investor positioning and especially in the valuations of defensives and cyclical stocks. Just as consensus fixed on trade and economic “crisis,” optimism was once again rekindled by a soothing policy response. The net outcome of this “cycle in a calendar year” is that global equity markets (measured by the MSCI All Country World Index in U.S. dollars) delivered +27.3%.¹ Quite some rebound from the panic in December 2018.

Alongside healthy equity returns, the year will be remembered for the market rotation in the later months of 2019 and the impact it has had on portfolio outcomes. Starting in September, factors rolled over, cyclicals jumped, defensive havens proved no longer defensive, and standard deviation events were freely quoted. Despite the positive outcome and the comfort this might imply, it was an uncomfortable year, but also one filled with opportunity.

While market levels have clearly reflected a change in sentiment, we do see economic improvement in the coming year, as policy response exerts an influence and as we compare growth with the low base levels a year ago. These low base levels were established as Chinese and U.S. economic stimulus wore off, in tandem with an auto sales and information technology (IT) capex recession, all within a backdrop of rising tariffs and a “trade war.”

One key insight represented in our strategy in mid‑2019 was the need to reduce our positioning in sources of defensive “stability” and the search for ideas in the growth cyclical segment of the market. While our carefully contrarian approach was at odds with investor sentiment gravitating toward low controversy stocks, the search for high‑quality cyclical growth companies in a deeply unloved segment of the market proved to be a rich source of opportunity and return from September onward. While we remained underweight “value” and deep cyclicals, including banks and commodities, we have seen our key positions levered to capital markets, semiconductors, automation, and U.S. housing contribute to a positive outcome for our clients in 2019.

(Fig. 1) Cyclicals Reborn
The second half of the year saw economically sensitive stocks outperform.
As of December 31, 2019

Importantly, while recent strength has backed stocks away from extremes, we remain excited by the prospects of select cyclical technology, automation, and industrial intelligence stocks. While isolating the secular winners on the right side of change is always our core thesis, integrated within our stock picks is the fundamental benefit from PMIs bottoming at a time when we also see an acceleration of semiconductor capex and inventory recovery, in what will be an important year for 5G mobile device innovation.

We are especially conscious of the unpredictability of a U.S. election race that remains wide open, with dispersed candidate and presidential outcomes. Given the shifting rhetoric in an election cycle, we are sharpening our watchlist as we see secular and defensive growth names underperform.

As a brief observation on the ongoing trade negotiations, the Trump administration remains focused on obtaining significant concessions from China heading into the election, given the inability to pass policy through a divided Congress. The case for trade reform between the U.S. and China is strong, and the incentives for a surface‑level agreement, especially for Donald Trump, clearly outweigh the cost of a U.S. slowdown or recession.

The case for analog and digital semiconductors is similar but nuanced. Analog involves taking real‑world measurements of temperature, light, and pressure and connecting those measurements to a computing platform. We will only see more of this over time, while what was once an industry defined by fierce competition has consolidated, helping the dominant survivors.

Digital semiconductors are the memory and logic of all devices and of the cloud. Dynamic random‑access memory (DRAM) was once isolated to PCs but has since spread to mobile computers (smartphones) we carry with us and rely on today. Now DRAM is spreading to become the “brain memory” for artificial intelligence and machine learning. We believe this will only grow.

We are also focused on the fundamental changes happening in semiconductor manufacturing. The semiconductor equipment sector has consolidated just at a point when physics has created an epic challenge for digital semiconductor makers trying to deliver innovation in chips. This is a powerful structural change benefiting those companies capable of advancing the industry further and should not be interpreted as merely a cyclical bounce on improved economic sentiment.

While creating significant challenges ahead spanning society, economics, and politics, one outcome of an era of disruption is the world of moderation we find ourselves in as equity investors. Not moderation in the day‑to‑day news flow or the dispersion of returns stock by stock, but moderation of the growth and inflation environment that has persisted. This is an environment defined by the middle ground that exists between crisis and excess. Importantly, this is a good environment for equity investors and especially for stock pickers willing to be uncomfortable.

Fading exuberance and factor moves, while focusing on secular changes that define long‑term winners, have been the key to delivering alpha in this market. We will, therefore, remain focused on active insights and keep applying a carefully contrarian spirit in a market environment that we believe will continue to confound global investors.