Global equities rebounded sharply in the second quarter, closely tracking a recovery in mobility data, from the re-opening of economies and a positive reversal of many leading economic indicators from the depressed levels of the COVID-19 lockdowns. Global Manufacturing PMI, which provides an indication of the direction of economic trends, improved significantly during the quarter with the June report suggesting a broad-based recovery is emerging. While the V-shaped recovery in equity markets and leading economic indicators is encouraging, a resurgence of COVID-19 cases in a number of geographies in June, and a corresponding flattening in mobility data rattled markets suggesting the path forward may be bumpy as governments may be forced to slow or reverse re-opening policies. Other risks that may impact the speed and strength of the recovery include: ongoing trade frictions, particularly between the U.S. and China, progress on a COVID-19 vaccine and further policy support.
Market leadership during the quarter was lower quality, beta and narrow, and was generally dominated by the "stay at home" stocks, which are heavily influenced by the mega-cap FANG stocks in the U.S. Markets in the European and Pacific regions generally lagged the broad ACWI benchmark, with Germany, the Netherlands and New Zealand notable exceptions. While emerging markets lagged overall, a number of markets across all regions outperformed significantly including South Africa, Brazil and India.
Sector performance was narrow, with the beneficiaries of the economic lockdowns producing the strongest results. Technology, led by technology software and electronic payment companies, was the strongest performing sector. The consumer discretionary sector also outperformed, benefitting from strength in online retail and home improvement stocks. Strength in media companies also drove outperformance in the communication services sector. The massive expansion of government deficits and central balance sheets to offset the economic contraction benefitted gold stocks and resulted in notably strong performance by the materials sector. Cyclical sectors like financials and industrials underperformed during the quarter; however, performance was volatile. Defensive sectors, such as consumer staples and utilities, were persistently weak during the period.
As would be expected, given the sector performance described above, factor performance was similarly narrow and, with a few exceptions, was led by growth and price momentum globally. While profitability factors like ROE outperformed, other quality factors, such as leverage and accruals, were weak. Market cap performance reflected the rotation away from quality, with smaller-cap stocks outperforming larger-caps. Despite an increasingly supportive macro and technical backdrop, value factor performance lagged during the period. With the robust market performance and declining global VIX indices, the low-volatility factor underperformed significantly during the period.
With the MSCI ACWI posting one of its strongest quarterly returns in history, the Sun Life MFS Low Volatility Global Equity Fund had difficulty keeping up. While the Fund’s emphasis on avoiding the most volatile stocks allowed it to produce respectable absolute performance, the beta-driven rally weighed heavily on relative performance. Another factor impacting results was the Fund’s exposure to higher-yielding stocks, which was negatively impacted by the overhang of potential dividend cuts and the low quality nature of the rally. Turning to the research inputs in our investment process, the Fund’s intersection holdings – stocks that are buy-rated from both our fundamental and quantitative research sources – produced uncharacteristically weak performance. Strong results from our quality focused fundamental research team were overwhelmed by the performance of the value component of the quantitative models, which were negatively impacted by the very strong performance of the most expensive stocks in the benchmark. Other factors in the quantitative models had a mixed impact on results.
The outcome of the research input performance described above was reflected in weak stock selection in the technology sector across multiple regions. Stock selection also detracted from results in the Europe (excl.-U.K.) and U.S. health care sectors, the Japan communication services sector and the U.S. consumer discretionary sector. The Fund’s positioning in a number of sectors, including overweight positions in utilities, real estate and consumer staples, coupled with an underweight position in technology, also detracted from results.
The size, breadth and quick implementation of fiscal and monetary policy helped fuel the unprecedented rally off the March lows and made a retest of the market lows unlikely. The re-opening of economies and improving mobility data, coupled with broad based increases in leading economic indicators, suggest a global economic recovery underway. The rotation into higher beta and smaller cap stocks, coupled with the narrowing of credit spreads, suggest the business cycle is transitioning from contraction to the recovery phase, which should result in more cyclical sector and value factor/style leadership. The unprecedented shutting down of most of the global economy in response to COVID-19 makes this downturn unique; however, investors have crowded into a narrow group of mega-cap growth stocks that has driven up the valuation spread between growth and value to the widest level since the tech bubble, which sets up the potential for a powerful reversal.
While most indicators point to an economic recovery and a corresponding rotation into early cycle leadership, the portfolio manager believes the market is unlikely to continue on the current "V" shaped trajectory. Many COVID-19 related risks remain, including a resurgence of the outbreak, a second wave as well as the success and timing of the development/distribution of a vaccine. Additionally ongoing trade frictions, social unrest and the upcoming U.S. elections have the potential to dampen the economic recovery and impact investor confidence.
Significant impacts on performance