by Diana R. Baechle, PhD
The US sector rotation triggered by the vaccine approvals last November has begun to fade in recent weeks. In fact, for the most part, the shifts in relative riskiness among sectors due to the COVID crisis have remained in place. So, was the market’s perceived “sector rotation” in Q4 just a “flash in the pan”? Was it driven merely by wishful thinking that the world was returning to the “normal” we knew before March 2020, with sectors that did not perform well during the pandemic making a comeback?
For most of 2020, Info Tech and Consumer Discretionary—the “pandemic profiteers1”—benefited greatly from the digitalization of social and work environments, posting enormous gains since April of last year. Other sectors, however, were crushed by the crisis, particularly Energy and Financials.
But in November, sectors’ fortunes seemed to turn on news of COVID vaccines and hopes of a return to “normalcy.” Both Energy and Financials saw sharp turnarounds in the final months of 2020, resulting in strong gains for Q4, although both sectors posted negative returns for 2020 overall. In contrast, Info Tech and Consumer Discretionary recorded relatively small gains in Q4, but were the best year-over-year performers among the 11 GICS sectors in the STOXX USA 900 index2.
What seemed to be the start of a sector rotation in Q4 2020 fizzled in January 2021. As we mentioned in last week’s Equity Risk Monitor Highlights, Energy and Financials lost ground, while Information Technology and Consumer Discretionary surged recently. Most sectors appeared to be reverting to the trends started by the pandemic.
The coronavirus crisis produced a seismic change in the relative risk of US sectors. In the first half of 2020, we saw traditionally defensive sectors, such as Real Estate and Utilities, turning into some of the riskiest sectors, while typically volatile sectors, such as Info Tech, joined the ranks of the lower-risk sectors.
By June 2020, Real Estate had become the second-riskiest sector after Energy, and Utilities was the sixth riskiest3, as measured by Axioma’s US median-horizon fundamental model. And they held those positions for the rest of the year.
In contrast, Info Tech went from being the second-riskiest sector at the end of 2019 to the fourth least risky at mid-year, and also maintained that rank to year-end.
Predictably in a pandemic, Health Care outperformed and remained the second least-risky sector (after Consumer Staples), compared with its usual middle-of-the-pack position.
The analysis of the historical behavior of sectors in the June 2020 blog The shifting sands of sector risk… When low-volatility sectors become high-volatility—and vice versa led us to anticipate that Info Tech would remain less volatile, at least until the end of 2020. And indeed it did, finishing the year among the least risky of the 11 sectors in the STOXX USA 900 index. Info Tech’s rank remained well below its historical median rank at the end of 2020.
For Real Estate and Utilities, we expected a reversion to their medians three to 12 months after May 2020. But nine months later, the two sectors are showing no signs of regaining their defensiveness, with ranks well above their medians. Perhaps this is not surprising, since the shift in relative risk and performance has been predicated on the massive changes in human behavior at the societal level, rather than being driven by a typical economic cycle. Massive unemployment prompted concerns that millions of people would stop paying their utility bills and rent, while demand for electricity and office space also declined.
Most sectors did not see their risk rankings change much, if at all, after the realignment that took place in the first half of the year. The exceptions were Consumer Discretionary and Materials. Materials became relatively less risky in the second half of 2020, its rank dipping further away from its historical median rank.
On the other hand, Consumer Discretionary became riskier in the second half of 2020, after its relative riskiness declined in the first half of last year. Given Amazon’s increasing dominance of Consumer Discretionary (over 30% weight), it may be that the high concentration of the sector was driving its relative risk up.
Note that in absolute terms, risk has fallen for all sectors since June, although at the end of 2020 it was still higher than at the end of 2019.
The significant changes in the risk characteristics of US sectors brought on by the pandemic seem to be here to stay—at least in the near term. Low-volatility sectors, such as Utilities and Real Estate, were not able to regain their defensiveness. Info Tech—a cyclical sector that has ranked among the riskiest sectors historically—remains one of the lowest volatility sectors. At the same time, sectors that have been benefitting from the pandemic continue to do so, while the big losers in this crisis are starting to lose ground again, after the short rally at the end of last year.
In fact, the economic shockwaves of the pandemic may have long-term structural effects. Many of the companies hit hardest to date may not live to see the recovery. That, or they will be completely restructured to the point where they switch sectors.
Companies are starting to rethink the need for employees to be physically in the office or to travel for business meetings, which, of course, will have major effects on Real Estate and Industrials (via Airlines). Countless hotels and restaurants have already closed their doors permanently, and so have many brick-and-mortar retailers, although some have been assimilated into mega online retail companies, impacting both Consumer Staples and Consumer Discretionary. Oil prices may recover when the economy begins firing on all cylinders again, but the course toward renewable energy and electric vehicles has been set, so Energy may not rebound as it has in the past. Utilities—the home of renewable energy companies—may rally instead.
[1] The credit for coining the term goes to our colleague Christoph Schon.
[2] For more details on sector performance in the fourth quarter and in 2020, please see Qontigo Applied Research Q4 2020 Insight Report – A Turbulent End to a Haywire Year.
[3] Sector risk is calculated by creating a portfolio of all stocks in a particular GICS sector in the STOXX USA 900. Weights, based on STOXX USA 900 weights, are then rescaled to add to 100%. The risk of each sector portfolio is then calculated using Axioma’s US medium-horizon fundamental model.
