Q4 equity manager report: Playing defense
Defense wins championships, the saying goes. Did it also help equity managers survive an otherwise bruising fourth quarter?
It appears so. Our manager research team found that defensive managers fared the best among active equity managers during last quarter's market selloff. We also observed many managers using the fall in markets as an opportunity to purchase securities at more attractive valuations. In particular, active managers have been finding value in companies that either continue to benefit from secular growth or are in commodity-related sectors, which sold off heavily at the end of the year.1
In addition, a number of active equity managers have highlighted emerging markets as a source of ideas, due to that sector's attractive relative valuation as well as the high proportion of growth opportunities present. We do note, however, that most managers continue to be mindful of political risks driven by trade tensions and upcoming government elections as they relate to this asset class.
At Russell Investments, our distinct relationship with underlying managers allows us to have unique access to insights from specialists across the manager universe--and there's arguably no better time to tap into these insights than during bouts of market volatility. With this in mind, we've compiled our chief tactical observations from key geographic and equity regions, in alphabetical order, for the fourth quarter of 2018.
Topping up on energy
- Managers have taken advantage of the decline in energy companies to increase their overweight to the sector. Gas exposure is the most favored, as managers believe that demand will exceed supply.
Increasing allocations to more defensive names
- Managers are wary of the impact of falling house prices on stocks reliant on the Australian consumer. As such, they've used the market pullback to increase exposure to healthcare and consumer staples. Due to their exposure to overseas demand, materials are also preferred.
Adding exposure to gold
- Some managers have bought or added exposure to gold companies. This is motivated by their view of the companies' production ability, with the defensiveness of the sector being secondary.
Energy lags, but concerns prevent adding on weakness
- With oil prices--specifically the Western Canadian Select oil price--continuing to be challenged, energy was once again one of the biggest sector laggards. However, the average hire-ranked manager did not add significantly on price weakness, as many of these energy stocks--especially the oil producers--could have significant balance sheet issues if oil prices stay at current levels.
Weeds pop up among cannabis stocks
- After the strong outperformance of cannabis-related stocks in the third quarter, these stocks gave back a lot of their gains in the October-to-December timeframe. Despite the pullback, managers continue to stay away from these stocks due to concerns around valuation, management quality and competitive dynamics.
Emerging market equitiesValuation upside offers high re-rating potential
- Emerging markets' relative cheapness to developed markets could attract some rotation from global investors.
- Volatility during the quarter has provided some emerging market managers opportunities in lowly valued cyclicals.
Selective high growth opportunities
- A number of emerging market managers are taking advantage of the selloff to purchase growth names at more attractive valuations (particularly in Asian consumer and tech).
- China A-Shares that fell aggressively on trade war fears could benefit from lower valuations, government stimulus and calmer trade tensions.
- H1 elections could act as catalysts in India, Thailand and Indonesia. India could benefit from the low oil price, early capex cycle and improved capacity utilization.
European equitiesPolitical risk continues
- Political uncertainty in the UK, Italy, France and Germany continues to impact market sentiment. On the margin, active managers have become more defensive and back traditional growth stories. Cash allocations have also increased.
- Value managers are finding more opportunities, particularly in the financials and energy sectors.
- European equity managers continue to be underweight the UK, specifically companies with heavy domestic exposures. Many managers are getting exposure to the market via larger cap companies that are more globally oriented.
Value manager capitulation?
- Value, as a style of active management, has struggled relative to growth for many years. We have observed more frequent cases of product closures in the value space.
Growth managers confident in secular growers
- Tariff, growth and rate concerns have increased volatility, but most managers see moderating but sustainable growth, which favors secular growers. Growth managers remain committed to their tech holdings, which offer low price-to-earnings growth.
Value managers are sanguine on cyclicals
- Volatility is providing opportunities, including in expensive defensives, but value managers maintain pro-cyclical positioning. They are sanguine on energy given still low capital spending and resilient demand. European banks have proven value traps for some, but U.S. and emerging market banks still offer positive risk reward.
- Quant managers continue to struggle in a volatile environment characterized by sharp changes in market leadership.
Managers less aggressive due to opaque market
- Given uncertainty over the global economy, especially China, managers have lowered allocations to the capital goods sector. Conversely, they have increased weights in defensive sectors, particularly telecommunications, which plunged following the announcement of plans to lower fees.
- Managers have maintained positions in technology due to their positive long-term view on the sector.
Increased focus on U.S.-China trade war
- Active managers as a whole are increasingly focused on possible effects from the trade war. While managers were already concerned about the direction of the economy, many believe that the situation will be exacerbated by the trade war. The overall impact is negative for Japan, but some believe that domestic machinery stocks could benefit due to a potential shift in production from China to Japan.
Investor concerns about Brexit continue to soar
- Many UK domestic-focused sectors performed poorly as worries of a no-deal exit from the European Union intensified.
- Managers continue to be bifurcated in their reaction to this. Some continue to avoid domestic plays, while others are excited by their cheap valuations and are adding to them.
While Brexit dominated the UK headlines, the UK stock market was stronger than other
- UK GDP (gross domestic product) growth and consumer-related economic indicators were positive toward the end of the year.
- On the margin, growth-oriented managers are becoming more positive on the market. Previously, it was just the value managers who were finding opportunities.
developed markets, and the economy continued to recover from the very poor start to 2018
U.S. large cap equities
Trade conflict contributes to risk-off contagion
- Despite several economic indicators suggesting continued growth (Institute for Supply Management surveys, retail sales activity and payroll numbers, among others), fear gripped the market and equity investors sought the exit. Concerns over the U.S.-China trade conflict and the possibility of a yield curve inversion sparked investor panic during the quarter.
- With the significant market selloff, active managers sought opportunities in discounted names.
- Russell Investments saw increased portfolio turnover across many active managers seeking to upgrade the valuation potential of their portfolios.2
U.S. small cap equities
Defensive value stocks dominate in a negative quarter
- Value stocks outperformed growth stocks in the fourth quarter. Despite this, the small cap growth index's valuation premium over the small cap value index (based on trailing and forward price-to-earnings ratios) continues to be above its long-term average.3 This suggests more room for value outperformance.
- The more cyclical value sectors--energy and materials--performed less well during the quarter. On the margin, active managers trimmed their energy positions during the period.
Outlook for high-growth stocks cooling?
- While still overweight high growth stocks, a number of Russell Investments' hire-ranked small cap growth managers incrementally trimmed their exposure to the growth stocks with the highest earnings surprise, 12-month price momentum and most expensive valuations.
The bottom line
With markets likely to remain volatile over the next several months, we believe it's more important than ever to pay attention to the thinking of specialist managers in order to identify potential opportunities for outperformance. As markets wax and wane, the views of active equity managers will likely do the same. Stay tuned as we continue to report on our observations from across the manager universe.
1 Source: Russell Investments equity manager research, Q4 2018. From hundreds of conversations with managers.
2 Source: Russell Investments manager universe analytics.
3 Source: Russell 2000® Growth Index, Russell 2000® Value Index. Data as of Dec. 31, 2018.