Market Positioning Shifts as Uncertainties Remain
With a continued flurry of negative geopolitical headlines and weakening economic data, but a relatively strong start to the fourth quarter earnings season, investors faced a challenging environment to make asset allocation decisions as 2018 wound down. Thanks to investors looking past the worst of the headlines and feeling more optimistic about the path of monetary policy and China-U.S. trade talks, global stocks posted their best month-of-January return on record after their worst ever December.1 At the same time, they did not come close to recouping December’s levels and continued to trade well below September’s highs. All this helped the bears stay trapped in 2018’s negative price action, while the bulls see last year’s sell-off as simply a reason to not make any moves. Looking underneath the markets’ surface makes it easier to parse out what really may be at play here, but points to conflicting trends.
For example, U.S. cyclical sectors outperformed U.S. defensive sectors by over 3% and U.S. small caps outperformed U.S. large caps by nearly 3% in the last month, signaling that investors rewarded companies with higher than market betas. They also favored emerging markets over developed markets by 1.59%, which typically coincides in periods of improving economic outlook. On the flip side, growth stocks again outperformed value stocks and the U.S. rallied to beat international by 0.92%. As detailed in Figure 1, only the one-month growth beating value and U.S. besting international follow the twelve-month trend.
Data represents the performance of one group of securities relative to another. For example, when the U.S. Small over Large bar is positive, U.S. small cap equities outperformed U.S. large cap equities. On the other hand, when the U.S. Small over Large bar is negative, U.S. small cap equities underperformed U.S. large cap equities.
MONEY IN MOTION
Unlike traditional flow reports that look at the entire set of ETFs in a given category regardless of how they are constructed, we focus on ETFs that specifically offer exposure to the intended underlying categories in order to more precisely identify trends. For example, the U.S. Large Cap category only focuses on ETFs that seek to track broad-based U.S. large cap equities and exclude ETFs that may be exposed to U.S. large caps, but may have other intended investment goals.
Under this view, investors took advantage of these differentiated trends to make distinct allocations across the ETF landscape. Last month’s flows highlight that ETF investors did not necessarily follow near-term or intermediate-term performance when making decisions.
While both U.S. large cap and small cap ETFs experienced outflows, small caps held up much better than large caps seeing $0.4 million of outflows while investors pulled $18.1 billion out of large caps. Flows were consistent with the nearly 3% return difference for small caps over the last month, driven largely by small biotech and real estate stocks outperforming large. However, over the last six months, large caps have outperformed small caps by over 6.6%, and ETF investors followed suit, allocating greater flows to large caps relative to small caps. This is not very surprising, given the risk-off sentiment that dominated much of the fourth quarter of 2018.
With three of the four defensive sectors underperforming the broad market by a relatively wide margin, cyclicals outperformed defensives by 3.30% in January. However, ETF investors continued to favor defensive sectors by a wide margin when it came to flows throughout January, and this was especially true over the last six and twelve months. Cyclical sector outflows were broad-based with Communication Services being one of the only clear winners. Much of this activity into Communication Services could likely be attributed to the revisions to the Global Industry Classification Standard (GICS) and the introduction of Communication Services as a sector back in September. While these are real flows and allocations to new sector exposure, they may not be representative of overall market positioning for cyclical sectors as a whole. Among defensive sectors, healthcare experienced the greatest inflows even as the sector underperformed the broader market last month.
Thanks to healthy overweights to the FANG stocks, growth outperformed value by over 1% in January, and while both categories saw net outflows over the last month, flows for growth held up better than value. Interestingly, the two have traded relatively inline over the last three and six months, while growth has dominated value by over 5% throughout the last twelve. However, when it comes to flows over these periods, it has been all about value as value ETFs have dominated flows between the two groups highlighting the pent up demand that investors have for a long-awaited value resurgence.
U.S. equity performance, relative to international, bounced back in January after underperforming in December, as flows continued towards international ETFs. However, the majority of outflows for U.S. ETFs came from the category’s two largest ETFs; such activity may have been driven more by capital market participants than asset allocators making strategic decisions to move out of the U.S. While the U.S. has dominated international by over 10% over the last twelve months, ETF investors have favored international exposure by over $32 billion.
While economic data has leaned towards being uninspiring, dovish remarks from both the Federal Reserve and the European Central Bank provided further upside support. The positive momentum for emerging markets continued for the third straight month, helping reverse some of the trailing twelve month performance that saw developed markets outperform emerging markets. At the flow level, emerging markets ETFs saw sizable inflows, while their developed counterparts experienced outflows. These trends showed signs of acceleration heading into the end of January.
Data represents the relative net flows of ETFs in the respective categories to another. For example, when the U.S. Small over Large bar is positive, U.S. small cap equities gathered greater flows than U.S. large cap equities. On the other hand, when the U.S. Small over Large bar is negative, U.S. small cap equities gathered less flows than U.S. large cap equities.
WHERE ARE WE GOING?
While fourth quarter earnings have generally been strong, global EPS revisions heading into earnings season were markedly negative, underscoring that the robustness of these earnings have potentially been lackluster. Specifically, U.S. small caps, cyclical sectors and international stocks have seen negative earnings trends over the last month. Corporate guidance has also been markedly negative. However, considering January’s broad-based bounce back from December’s lows, slowing earnings growth may now be priced in.
On a positive note, an index measuring global economic data against their estimates remains negative, but seems to have bottomed in early January after being in a downtrend since last September. For example, the relatively muted response to Italy entering a technical recession may be an example of slowing economic growth beginning to be reflected in prices. While many investors expected to see diverging monetary policy in 2019, recent dovish comments from both the Federal Reserve and the European Central Bank imply greater synchronization. However, financial conditions should continue to tighten as central balance sheets decline, as maturing assets are not replaced with newer issues. Leading economic indicators suggest that risks remain skewed to the downside. Going forward, this will likely lead to investors rewarding companies and market segments that can display resilient growth and punish those that do not.
FIGURE 3: ECONOMIC SURPRISES AND REVISIONS MAY HAVE FOUND A BOTTOM IN JANUARY
Source: Bloomberg Finance, L.P., as of January 31, 2019. Economic surprises are represented by the Citi Economic Surprise Index – Global and revisions are represented by the Citi Economic Revisions Index – Global.
While the yield curve steepened following Federal Reserve Chairman Powell’s press conference, the difference between 3-Month T-Bill Rate and 10-Year U.S. Treasury Yields, a classic definition of the yield curve, experienced a notable move lower towards zero as investors continue to expect the yield curve to touch zero, and perhaps invert. This is interesting, and it represents a shift in the source of flattening pressure over the previous few years, where increases in the federal funds rate were the primary driver of a flattening yield curve. As investors have begun to reduce expectations for future interest rate increases, the driver of flattening pressure over the last three months has been the dramatic move lower in 10-Year U.S. Treasury Yields. This could be perceived as a signal that the market is pricing in higher risks of an economic downturn.
Thanks to last year’s selloff, valuation multiples declined across the board under various measures. While valuations have been attractive for international stocks relative to U.S. stocks, EPS expectations offer a more mixed picture, as international earnings are expected to be materially less than in the U.S. in 2019 and beyond. These forward expectations highlight the challenging environment that companies outside of the U.S. face considering the threats to globalization and trade, factors for which most large firms outside of the U.S. depend on to fuel their revenue and earnings growth.
FIGURE 5: U.S. STOCKS CONTINUE TO TRADE AT HIGH MULTIPLES RELATIVE TO U.S.
Source: Bloomberg Finance, L.P., as of January 31, 2019. Data displayed is the monthly price-to-sales ratio for U.S. stocks represented by the Russell 1000 Index and international stocks represented by the FTSE All-World ex US Index.
On the other hand, the richness of U.S. value stocks to growth stocks is far from extreme thanks to the multiples compression that growth stocks experienced in 2018 relative to value. Over time, as illustrated below, this differential tends to be driven by investor’s bidding up and down shares of growth. Looking ahead, the relationship between technology stocks and financials will likely be key to the relative performance of the pair even more so the slope of the yield curve.
FIGURE 6: GROWTH STOCKS RELATIVE VALUATION TO THE U.S. IS FAR FROM EXTREME
Source: Bloomberg Finance, L.P., as of January 31, 2019. Data displayed is ratio between the monthly price-to-sales ratio for growth stocks represented by the Russell 1000 Growth Index and value stocks represented by the Russell 1000 Value Index.
1 As measured by the total returns of the MSCI ACWI.
|U.S. Large Cap||Russell 1000 Index|
|U.S. Small Cap||Russell 2000 Index|
|U.S. Growth||Russell 1000 Growth Index|
|U.S. Value||Russell 1000 Value Index|
|U.S. Cyclical Sectors||MSCI USA Cyclical Sectors Index|
|U.S. Defensive Sectors||MSCI USA Defensive Sectors Index|
|U.S.||Russell 1000 Index|
|International||FTSE All-World ex US Index|
|Developed Markets||MSCI EAFE IMI|
|Emerging Markets||MSCI Emerging Markets IMI|
- MSCI ACWI: The MSCI ACWI captures large and mid-cap representation across 23 Developed Markets and 24 Emerging Markets countries. The index covers approximately 85% of the global investible equity opportunity set.
- Russell 1000: The Russell 1000 Index consists of the largest 1,000 companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. companies.
- Russell 2000: The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
- Barclays Global Aggregate Index: The Bloomberg Barclays Global Aggregate Bond Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
- VIX: The Chicago Board Options Exchange Volatility Index reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes.
- Russell 1000 Value: The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
- Russell 1000 Growth: The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
- MSCI USA Cyclical Sectors: The MSCI USA Cyclical Sectors Index is based on MSCI USA Index, its parent index and captures large and mid-cap segments of the US market. The index is designed to reflect the performance of the opportunity set of global cyclical companies across various GICS® sectors. All constituent securities from Consumer Discretionary, Financials, Industrials, Information Technology and Materials are included in the Index.
- MSCI USA Defensive Sectors: The MSCI USA Defensive Sectors Index is based on MSCI USA Index, its parent index and captures large and mid-cap segments of the US market. The index is designed to reflect the performance of the opportunity set of global defensive companies across various GICS® sectors. All constituent securities from Consumer Staples, Energy, Healthcare, Telecommunication Services and Utilities are included in the Index.
- FTSE All-World ex US: The FTSE All-World Excluding United States Index is a free float market capitalization weighted index. FTSE All-World Indices include constituents of the Large and Mid-capitalization universe for Developed and Emerging Market segments.
- MSCI Emerging Markets IMI: The MSCI Emerging Markets Investable Market Index (IMI) captures large, mid and small cap representation across 24 Emerging Markets (EM) countries.
- MSCI EAFE IMI: The MSCI EAFE Investable Market Index (IMI), is an equity index which captures large, mid and small cap representation across Developed Markets countries around the world, excluding the US and Canada.
- Bloomberg Commodity Index: Bloomberg Commodity Index (BCOM) is calculated on an excess return basis and reflects commodity futures price movements.
- CRB Raw Industrials Spot Price Index: Commodity Research Bureau Raw Industrials Index measures price movements of basic raw industrial commodities.
Risks: Investing involves risk including possible loss of principal. The ETFs’ investments in derivatives may pose risks in addition to, and greater than, those associated with directly investing in or shorting securities or other investments. There is no guarantee that the returns on an ETF’s long or short positions will produce high, or even positive returns and the ETF could lose money if either or both of the ETF’s long and short positions produce negative returns. Please see the summary and full prospectuses for a more complete description of these and other risks of the ETFs.
Distributor: Foreside Fund Services, LLC