The Cyclical Rally: Why It's Time To Be Carefully Contrarian

March 2017
David J. Eiswert , Portfolio Manager

 

In this interview, David Eiswert explains why he is positioning his strategy to be carefully contrarian in the face of today’s cyclical rally and what that means for his portfolio.

 

LAURENCE TAYLOR: Hello, I’m Laurence Taylor, Portfolio Specialist at T. Rowe Price and I’m joined today by David Eiswert, Portfolio Manager for the Global Focused Growth Equity Strategy. David, we’ve obviously seen a lot of market sentiment moves in the last twelve months or so; what do you think the market is telling us with this last cyclical rally, in particular, and what does it mean for the portfolio, if anything?

 

DAVID EISWERT: Thanks Laurence. I think the narrative after the Global Financial Crisis, in general, was one of stagnation. And I think in the last seven or eight years you saw a lot of investors gravitate towards low volatility, high yielding bond proxy types of portfolios, and, in general, that reflected their view that the world was stagnant, that we lacked growth. Combine that with the shock we saw early in 2016 when some volatility in China and the pressure of falling oil prices had the effect of signalling a recession and I think you saw almost a crescendo early in ’16 where people fled any kind of cyclical exposure. So, multiple years of a focus on a stagnating global economy pushing people into low vol and yield combined with that shock early in ’16 around cyclicals really caused the flushing out. There was really no-one betting on those areas of the market.

 

As 2016 played out, we saw more stabilisation in the economy and that was the first leg of cyclicals rallying. The second leg was really the shock, not only of Brexit, because Brexit is symbolic of populism, but of Donald Trump winning the US election, which really solidified this global view of populism, populism leading to changes in government structures, and ultimately I think the market believes leading to fiscal policy. Think about it as democracies voting away stagnation, voting for radical candidates who offer promises of growth primarily driven by fiscal – fiscal means cutting taxes, raising fiscal spending – so that cocktail led to a very powerful shift in the market and because of the positioning over the last seven or eight years caught most investors flat-footed, where they simply didn’t believe it was possible for an acceleration in growth, driven by something like fiscal policy.

 

LAURENCE TAYLOR: OK. And in terms of the moves we’ve seen in the market, and where you see actual changes in fundamentals, positive changes and where you don’t, could I try and break out where you see real impact versus perhaps where sentiment has just leading prices up.

 

DAVID EISWERT: So, if you take a step back, it’s hard not to argue that we are at least mid- and potentially late-cycle, post the last global recession which was the Global Financial Crisis. We’ve had many years of growth and strong asset returns. So, it’s difficult to argue that we are early cycle. If you look at unemployment statistics, if you like at PMIs, if you look at growth in general, we are not coming off a trough of any of those things, so you can pretty clearly believe you are not at the bottom of a big cyclical rally. That said, for many parts of the industrial economy, 2017 represents a year of relatively easy comps (comparisons) off of 2016, so you do see some modest acceleration.

 

Now I think you would have to argue that the way asset prices have moved, especially by sector in the cyclical areas, they really reflect the belief in a change in regime. I would characterise that change in regime as mainly being, or most simply being a change in a shift from deflationary expectations to inflationary expectations, and again driven by some of the populism and fiscal policy that we discussed earlier.

 

So, you’re seeing the market embrace this idea of inflationary expectations. At the same time, it’s late in its cycle. So it’s quite a dangerous combination, and I think, you can look across different sectors and the danger, I think, is at different levels.

 

I think industrials, there are a lot of actual results that need to come through to support the current mood. I would compare that with financials, where I think financials were such a shunned area of the market in the past seven or eight years, and there’s been so much change in industry structure in financials in terms of capacity exiting and companies changing their structures that you could see operating leverage, you could see valuation expansion in financials.

 

So I’ll contrast those two, although they’ve both been driven by the value cyclical rally. I think we see more opportunity in financials. We need less actual improvement for financials to be a good sector than we need for industrials, where we actually need a pretty strong fiscal pulse to affect industrials. We actually need infrastructure spending in a very large way, whereas in financials you could see modest inflation and modest fiscal spending which could lead to financials continuing to be an attractive sector.

 

LAURENCE TAYLOR: And in terms of, in taking a step back including us on this video, we’re talking about politics, macro, big themes around the cyclical rally, as the market reprices much, much more growth, there’s obviously a risk that people forget about stock-specific, and perhaps focus less on some of the themes eighteen months ago that we were seeing where growth was higher priced than value, where individually or an industry basis are you most encouraged in the portfolio today given the outlook that we have. Where do you have most high conviction today when you look at the portfolio?

 

DAVID EISWERT: I think the way we’ve managed the portfolio in the last five years, if I pull out a thread of where we’ve made good decisions in managing the portfolio, it has been to be carefully contrarian. And what I mean by that is that there a number of powerful forces that are affecting the global economy: technological change, automation, demographics. These have not gone away.

 

So, despite the real change that populism has caused in political systems, and the real potential for fiscal policy, there are pressures exerted exogenously on the global economy that you need to keep in mind and you can’t forget just because of an election change or some fiscal policy. So that leads us at this moment to be, again, carefully contrarian and looking for the sectors where this rally in cyclicals and shunning of defensives opens up opportunities for individual stocks, and I think that’s critical. And it’s actually the power of the strategy that we run in Global Focused Growth: we limit the number of names that we own, we’re much more interested in alpha than beta, and so it really gives us the potential to really focus on one or two names within a sector. And if that sector is for  example, healthcare, which has been under a lot of pressure in the last two years and a lot of pressure in this cyclical rally, we’re able to go into that industry, pick out one or two individual stocks that have strong growth drivers, independent of the cyclical rally, or fiscal stimulus or anything like that, independent of that, stock-specific drivers and focus on those.

 

Same thing in financials, we can really separate financials around the world and we can focus in on those stocks that benefit the most, or perhaps need the least real tailwinds to be great stocks.

 

So we are being carefully contrarian, leaning a little bit against the cyclical rally, not extremely, but a little bit against and then again, looking for those specific stocks that have been thrown out with the rally but offer characteristics that we have found lead to alpha over time.

 

I think this is the time to be carefully contrarian; it’s not the time to pile into the value cyclical rally. And, again, I’ll stress there are powerful forces affecting global growth, affecting the way we work and live, and we need to be reminded of that in a time when there seems to be a very herd-like rally based on some changes in politics.

 

LAURENCE TAYLOR: So, presumably this year will be a very big year in terms of that earnings differential across the market which is normal and natural, hitting these big macro themes in industrials versus financials. Are we seeing, already year-to-date in earnings season, that you’re starting to see some of that differentiation come through? Are you seeing dispersion in returns early in this earnings season?

 

DAVID EISWERT: I mean, certainly for us, knock on wood, it’s very early in the earnings season, but a number of our names, apart from any thematic rally, are delivering results based on their stock-specific characteristics. You can see that in technology, consumer discretionary, which has been a very controversial sector, we have been able to identify those stocks and those companies that really despite the external factors, are delivering results and beating investors’ expectations apart from the rally. So we’re very much focused on that stock-specific element at this point. That is, the stock-specific element is the element that will lead you through the valley of very macro trading, very ETF-driven kind of trading. So, we see that already in this earnings season in that, again the stock selection and the focus that we put on owning a fewer number of names very much paying off.

 

LAURENCE TAYLOR: David Eiswert, thank you very much for your time.

 

DAVID EISWERT: Thanks Laurence.

 

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