February Wrap Up: Rotation and war

While the US market closed slightly lower, global markets rose over the month. That hinted at what has been a fascinating rotation. Last year's winners became this year's trailing stocks while stocks and markets ignored last year have posted strong returns. This is a good reminder that markets don't move in straight lines. Eventually momentum wears out for even the most "exciting" names, and the laggards become sufficiently cheap to catch buyers' interest, leading to a rotation in market leadership. This is a strong but nuanced investment "rule" to bear in mind as you invest - the value of contrarianism. For us, it underpinned our early overweight investments in emerging markets and infrastructure shares, positions that have paid off handsomely. 

The "Great Rotation" has been one of the dominant themes in markets so far this year, driven by shifting valuations, changing perceptions of the impact of the AI build-out, and changing macroeconomic policy. This has manifested itself in three primary ways.

1.       The "HALO" Trade: 

The most dramatic rotation has been the flight from AI software names into "old economy" sectors like materials (copper has been a standout), industrials, energy, and consumer defensives. Wall Street analysts have dubbed this the "HALO" trade, standing for Heavy Assets, Low Obsolescence.

The "HALO" trade was kicked off by a dramatic sell-off in software names as autonomous AI agents demonstrated the ability to independently execute complex corporate functions. This dynamic threatens the "moat" of software firms, making investors question existing business models and casts a pall over the right value for them. The market is also beginning to worry about the massive capital expenditures of the hyper-scalers, like Google and Amazon, and whether it will deliver an adequate return on capital.

On the flip side, capital rotated into the physical infrastructure required to power AI. Caterpillar became an unlikely AI proxy, surging over 31% year-to-date as its industrial equipment is deemed critical for data centre construction. Consumer staples like Walmart and Costco also hit record highs as investors sought defensive shares.

2.       The Size Shift:

For the first time in years, smaller, domestically focused companies began to outperform large-cap peers. Between January and February, the Russell 2000 small-cap index staged a strong run, outperforming the S&P 500 for fourteen consecutive trading sessions - a streak not seen since 1996. The index delivered a 25% trailing twelve-month return, substantially beating the Nasdaq 100 and S&P 500.

3.       The Geographic Pivot: US Exceptionalism to International Value:

The final leg to the rotation has been global, with capital migrating away from the highly concentrated, expensive US market towards cheaper, international markets.

European and Japanese share markets have been real beneficiaries of this theme with strong performance, particularly in Germany, which is rolling out massive fiscal spending. The pan-European Stoxx 600 and the UK's FTSE 100 both hit record highs in late February, heavily supported by the rotation into the energy, materials, and industrials sectors that dominate those indices.

The discipline to remain well diversified and to allocate further capital to investments that are lagging is an important way we seek to grow your wealth. This is typically captured through our yearly assessment of the returns that each asset type offers and implemented into portfolios via our Strategic Asset Allocation process.

 While there is more to this process than just valuations, cheaper assets, particularly if they are good diversifiers, typically shine through and will warrant a bigger allocation in your portfolio. This helps us get ahead of the kind of rotation that has just happened and helps us profit from it.

Our early overweight investments in emerging markets and infrastructure shares, positions that have paid off handsomely in the rotation, are good examples of this.

Escalating geopolitical tensions in the Middle East have prompted discussion about potential market impacts for investors. The papers, X and our social media feeds will be full of theories on how the conflict will play out and the effect it might have on markets. The reality is that none of us really know.

The past might provide a guide though. The key takeaway from our analysis is that the average conflict results in a very short-term drawdown of roughly 5% (using the S&P500 as a proxy), with the market recovering its losses over an average of 47 days. After 12 months, the S&P 500 has been higher 68% of the time following these events, mirroring its standard long-term return distribution.

While volatility is likely to be heightened right now, its typically short-term, and no response is usually the best response for investors to take.