Any ‘V’-shaped recovery in cyclical stocks is unlikely to last, as there is a lot for markets and investors to “worry about and digest”, according to Rathbone Investment Management’s Alexandra Jackson.
The manager of the £40m Rathbone UK Opportunities fund said "staggering" stimulus measures from central banks and governments had buoyed markets after their Covid-19 falls into bear market territory, despite "horrifying" fundamentals.
Jackson noted global lockdowns had led to an unprecedented wave of downgrades to analysts' earnings expectations, "yet central banks have never unleashed such a wave of liquidity and support so quickly".
While the stimulus "seems to have worked so far", with investors "concluding that central banks have done enough to hold the line between a public health crisis and a financial crisis".
However, "liquidity alone cannot support a bull market forever", she claimed, suggesting a number of optimistic assumptions needed to play out in the near term for the market rally to broaden out.
"At some point, you need to see an improvement in the fundamentals for the pace of downgrades to slow, concluding that central banks have done enough to hold the line between a public health crisis and a financial crisis for that rally to broaden out," Jackson said.
Some of those points are coming through now, the manager conceded, with infection rates having peaked, lockdowns having been eased and macro indicators, like purchasing managers' indices, bouncing off very deep lows.
As this continues, we are likely to "get a strong rotation into the more cyclical, more economically sensitive, areas of the market", but Jackson thinks "there is still a lot to worry about, and a lot to digest post this initial ‘V'".
Material earnings uncertainty
She explained: "Geopolitics is back in the spotlight, fundamentals look weak [and] consumer behaviour is unlikely to spring back in the same way.
"Retail sales, which I think is a better indicator of demand than PMI surveys, have actually been quite sluggish, even in China. Spending is shifting quickly; online spend has risen above pre-Covid levels at the vast expense of offline.
"Rightmove is over-run, home maintenance and repair is surging, but hotel occupancy in China, for example, is still only a third of the norm. easyJet doesn't see flight bookings back to previous levels until 2023. Consumers say they are reluctant to go to restaurants and cinemas.
"So early ‘V' now, yes, but we see a more protracted recovery than some, and to pile into cyclical areas of the market you need to believe that we will see this perfectly carry on, [with] no second wave, an imminent vaccine and a rapid reduction in the unemployment rate."
Most importantly, Jackson said, investors need to believe bond yields will move sustainably upwards in order for cyclicals to outperform.
However, that is unlikely. "It is important that we do not get into this vicious spiral that we had in 2008 between unemployment, wages and profits. We will need continued central bank action on that, which is going to act as a lid on rising bond yields."
While a slight broadening out of the market rally, particularly towards European indices, is welcome, once the ‘V' ends, "we see material earnings uncertainty, particularly in economically sensitive areas".
Reducing 'lockdown losers'
Rathbone UK Opportunities has lost 10.6% in the year-to-date, according to FE fundinfo, outperforming both its IA UK All Companies sector peers and FTSE All-Share benchmark's losses of 15%.
Jackson puts the fund's outperformance down to its underweight or shunning of sectors like retail, mining, oil, banks and travel, and an overweight to technology names.
Its winners include video games makers Team17 and Keyword Studios, which are both up 40% and 20% respectively year-to-date, with both seeing surging purchases and engagement during lockdown.
Elsewhere, Ceres Power, which power data centres, buses and boilers in a cheap and scalable way, has doubled through the course of the year by "riding the renewable energy wave". Abcam, too, has performed well, with interest in its antibodies at high levels.
Detractions have come from the likes of Gym Group, which has seen its sites temporarily closed down, airport and railway café operator SSP, as well as student accommodation provider Unite.
Jackson said the fund had been "reducing exposure to our lockdown losers", despite some, including SSP, having rallied hard in recent weeks.
Jackson said the fund's analyst, James Workman, had assessed the fund's holdings, as well as those on its watch list, "to judge viability by looking at each company's cash cost base and their working capital needs".
"This helped to reveal the impact of a fall in revenue on the near-term profitability of the business, as well as its solvency," reasoned Jackson.
"By doing this, we were ready when the many cash calls started to come and we supported the majority of our existing holdings who needed fresh equity, recycling cash from the worst performing parts of the fund."
The manager said the fund had "topped up a few favourite holdings" including security firm Chemring, but trading had been at low levels, bar the purchase of "a world leader in driverless technology".
Over Jackson's six-year tenure, the fund is up 21.8%, narrowly ahead of both peers and the benchmark at 20.1% and 19.2% respectively.