Writing in a blog, Ms Shah said that while major equity indices may appear to be essentially unchanged, this conceals the true state of the equity market.
“This week we saw one of the largest three-day rotations, from momentum to value, in over 30 years," she said.
“Over the past year or so, most of the S&P 500 gains have come from defensive sectors and growth stocks, but valuation extremes and overwhelmingly bearish investor positioning had rendered the market vulnerable to rotation, and in recent days, the bond sell-off appears to have spurred a turnaround.”
On the other hand, Ms Shah noted that the initial part of the rotation was largely technical, and that signs of improving investor optimism are suggestive rather than decisive. She stressed that the next phase will need to be supported by a fundamental upturn in global economic activity.
“Markets have definitely become too pessimistic about growth prospects in recent months, and we’ve seen sovereign bonds pricing in a recession. At present, however, stabilisation in growth, strongly supported by synchronised global central bank easing, is a more plausible scenario than an outright recession,” she said.
“However, monetary easing on its own won’t kindle a sustained recovery – and given trade tensions have been a major driver of the global growth slowdown, a complete trade resolution will be necessary for a sustained global recovery to take hold.”
The investment strategist believes that China’s recent decision to suspend tariffs on some US imports for one year is a clear positive, as is President Donald Trump’s delay to the planned 1 October increase in tariffs in response.
“It’s clear that these positive moves have nurtured the recent recovery in risk appetite – but if you asked me whether these gestures of goodwill are a sign that a full resolution of US/China tensions is in the works, I would have to say that I’m cautious. With the two sides still diametrically opposed on several fundamental issues, a comprehensive deal surely remains out of grasp in the near term,” she said.
While she admits that the extreme pace of this week’s rotation is probably unsustainable, Ms Shah said there is still little sign of investor capitulation, so another leg up is possible.
"Cyclicals, small caps, and value are likely to rebalance further in the coming weeks. At the same time, expensive defensives, growth stocks, and large caps may come under pressure,” she said.
“Does this mean investors should dump bonds and bond-like proxies en masse? Definitely not. We are still facing some underlying economic weakness, and trade negotiations can be undone at any moment. But partially reducing exposure to bond-like proxies to fund some exposure to cyclicals would be my preference.
“On rare occasions, sitting on the fence is advisable.”