One Thing And One Thing Only.
- Market Drivers: The ongoing timeline of trade rhetoric points to potentially worrisome momentum. From 25% tariffs on an additional $250 billion of Chinese goods and threats of restrictions on rare earth minerals, to the introduction of potential tariffs on Mexican exports to the U.S., May can seemingly be summed up by two words: trade war.
- Performance: From a relative value perspective, May resulted in notable movement. Defensive Sectors dramatically outpaced Cyclical Sectors in a quick reversal from April. Emerging Markets continued to underperform Developed Markets, and while Growth beat Value for the sixth consecutive month, we continue to watch this relationship as an important proxy of growth concerns.
- Flows & Positioning: Across the entire ETF industry, overall positioning spoke towards more cautious investor sentiment, as investors de-risked across a range of market segments and equity styles. From a relative strength in flows perspective, International exposures were notably favored relative to the U.S., and Growth continued its favored trend relative to Value.
- What’s Next?: The current volatility increase seems likely to continue in the short-term. Investors will be looking for either material progress on the ongoing and growing trade war or a change in tune from the Federal Reserve, which has not yet occurred, to help boost sentiment.
May’s market action can be summed up by two words - trade war. It seemed to be the only driver of equity market performance both positively and increasingly negatively. An apt Bloomberg headline referenced that investors were awaiting the next tweet from President Trump to help set the direction.1
Amid this focus on largely unsubstantiated progress or setbacks on the China-U.S. trade talks, U.S. corporations posted better than expected earnings, but that was not enough to prevent this month’s pullback as investors may be considering the recent past a poor prologue for an increasingly uncertain macro environment.
Even so, market action over the last month was unique from Q4 2018. Sentiment in Q4 was driven more by investor concerns that the Federal Reserve would too aggressively tighten monetary policy. Today’s sentiment, however, is related to investor realization that even before the trade war heated up, global growth has been slowing. More troubling is the persistent decline in yields around the globe as the bond market is telling stocks that the growth picture will be less rosy going forward. In addition to parts of the U.S. Treasury yield curve inverting again, inflation expectations continue to decline and stand at 2 year lows under a widely followed measure calculated by the Federal Reserve Bank of St. Louis.
FIGURE 1: Inflation Expectations Continue To Decline
Source: Bloomberg Finance, L.P., FRED, as of May 31, 2019.
RELATIVE VALUE THEMES
Last month, the average spread between the five equity index pairs that we track, irrespective of direction, was 1.45%. Looking under the hood reveals some notable activity among the relative relationships between these market segments.
CYCLICALS V. DEFENSIVES
Cyclical sectors, which outperformed defensive sectors by 6.56% throughout the month of April, and had outperformed defensive sectors by 13.20% throughout the first four months of 2019, underperformed by -3.10% in May as a result of negative trade rhetoric, and a 10-Year U.S. Treasury Yield that fell from 2.405% to 2.164%. This drubbing was broad based as five of the six cyclical sectors underperformed the market with the expectation of Communication Services outperforming. On the flip side, Real Estate and Utilities outperformed the broader market by over 500 basis points, and Consumer Staples names outperformed by nearly 400 basis points. The Defensive Sectors basket was not without its own laggard, as the Energy Sector struggled in May as oil fell over 11%.
EMERGING V. DEVELOPED MARKETS
Emerging Markets (EM) continue to be a notable underperformer relative to Developed Markets (DM). Year-to-date, EM has underperformed their DM counterparts in three out of five months. Over the trailing 12 months, EM has underperformed in eight of the 12. The -2.13% underperformance throughout the month of May was largely driven by continued strength in the U.S. dollar3 and EM ties to the global trade ecosystem, and it was the largest monthly underperformance since June 2018. However, this theme is potentially showing some signs of “bottoming out”. Even if it proves to only be a temporary sign of strength, EM provided over 300 basis points of outperformance relative to DM during the last week of the month.
VALUE V. GROWTH
We are also watching the relationship between Value and Growth stocks closely, as the behavior of this pair may be telling of the market’s perception of “growth fears” via an equity expression. While Value underperformed Growth (on a monthly basis) for the sixth consecutive month, it was the lowest relative underperformance since November 2018. A reversal in this theme could be a sign that market participants are less willing to pay hefty premiums for growth rates that appear to be slowing. Keep in mind, however, that value stocks face an ongoing flattening yield curve that hurts its largest sector – Financials – disproportionally.
Prior to the recent sell-off, investors had broadly favored market segments with the greatest earnings growth potential, regardless of whether it required paying up from a fundamental perspective. Some of the 1-month relative performances look similar to what we saw throughout Q4 2018. Relative value themes may be telling of underlying market dynamics.
Should investors go hunting in the bargain bin, U.S. Large Cap Value stocks and Developed Market stocks appear to the most likely candidates due to their relatively attractive PEG Ratios.4 Although, this is not our base case for either pair. Italy’s challenges with the ECB and the seemingly never-ending Brexit saga do not make the case to dive into the Developed
Markets water easy. A potential trade war with Europe and now Mexico will also weigh on near-term sentiment.
3As portrayed by the U.S. Dollar Index (USD), which indicates the general international value of the U.S. dollar.
4PEG Ratio is the price-to-earnings (P/E) ratio divided by the growth rate of earnings for a specified time period.
FIGURE 2: Relative Value Themes & Market Dynamics
Source: Bloomberg Finance, L.P. as of May 31, 2019.
RELATIVE WEIGHT WINNERS & LOSERS
With this month’s declines being so broad-based, no Relative Weight pair had positive absolute returns. Even with last month’s change in direction, however, trailing 3-month and year-to-date performances still look relatively strong, and outperformance is still intact with some of the relative weight winners.
The largest performance spreads in May were seen across the Cyclical and Defensive Sectors ETFs (+ 3.10%, Defensives), and the Emerging and Developed Markets ETFs (+ 2.13%, Developed Markets). The largest performance spreads over the trailing 3 months were seen across U.S. Small and Large pair (+ 5.74%, Value), and Value and Growth ETFs (+ 3.20%,
Developed Markets). Year-to-date, cyclical sectors have outpaced defensive sectors by 8.86%, which is by the far the largest relative spread among the five pairs. Figure 3 shows the relationship between these ETF pairs over the month of May, the trailing 3 months, and year-to-date periods.
FIGURE 3: Relative Weight Winners Holding Their…Weight
|1 Month||3 Month||Year-to-Date||1 Month||3 Month||Year-to-Date|
|U.S. Large over Small||-5.69%||1.97%||0.117||U.S. Large Cap||-6.37%||-0.90%||11.05%|
|U.S. Small over Large||-8.50%||-9.52%||0.0813||U.S. Small Cap||-7.78%||-6.64%||9.26%|
|Growth over Value||-6.29%||2.24%||0.1621||Growth||-6.32%||0.70%||13.68%|
|Value over Growth||-6.51%||-4.15%||0.0577||Value||-6.43%||-2.49%||8.45%|
|Cyclical over Defensive Sectors||-8.78%||1.45%||0.1803||Cyclical Sectors||-7.21%||0.15%||13.74%|
|Defensive over Cyclical Sectors||-2.58%||-4.65%||0.0034||Defensive Sectors||-4.11%||-2.90%||4.88%|
|U.S. over International||-6.98%||-0.40%||0.1281||U.S.||-6.37%||-0.90%||11.05%|
|International over U.S.||-4.66%||-2.84%||0.051||International||-5.15%||-1.96%||7.37%|
|EAFE over Emerging Markets||-3.94%||-0.41%||0.0926||Developed Markets||-4.87%||-1.62%||7.69%|
|Emerging Markets over EAFE||-8.21%||-6.04%||0.0177||Emerging Markets||-7.01%||-4.43%||3.92%|
Source: FTSE Russell, MSCI, and Bloomberg L.P. as of May 31, 2019. Past performance is not indicative of future results.
MONEY IN MOTION
Unlike traditional ETF flow commentary that includes 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, our U.S. Large Cap category only focused on ETFs that seek to track broad-based
U.S. Large Cap equities and excludes ETFs that may be exposed to U.S. Large Caps, but have other intended investment goals, such as a style or factor tilt.
LARGE AND SMALL CAPS BOTH SUFFER
Driven by outflows from products favored by traders as opposed to asset allocators, both U.S. Large Cap and Small Cap saw outflows last month. Large Cap was hit especially hard with investors yanking over $12.5 billion out of the largest ETF in the category. However, even in the face of market volatility, those ETFs used primarily by asset allocators saw net inflows.
INVESTORS STILL FAVORING GROWTH
In contrast to previous months, both U.S. Large Cap Growth and Value ETFs took in new money, but Growth continued its recent money gathering momentum and outpaced Value’s inflows by $768 million. While the monthly performance spread for Growth relative to Value was the lowest in six months, investors continue to favor growth names in terms of flows and
MORE FLOWS INTO CYCLICALS (THIS MONTH)
On the other hand, investors spent the month of May reducing exposure to both Cyclical and Defensive Sectors with $3.25 billion out of Cyclicals and $2.19 billion out of Defensives as ETF investors seemingly choose not to discriminate between either group. Notable, however, is the pace and frequency of the relative strength in flows between these market segments. Cyclical and Defensive sectors have alternated leadership in flows on a monthly basis throughout the entire calendar year. Figure 4 shows the month-over-month relative strength in flows between Cyclical and Defensive Sectors.
The only sectors with inflows this month are Information Technology (Cyclical), Utilities (Defensive) and Consumer Staples (Defensive), while Energy and Healthcare are the laggards with a combined $2.40 billion of outflows. This mix between outperforming and underperforming groups shows that investors have been pickier with their allocations, and may actually be looking for distinct opportunities during this recent downtrend.
WILL INVESTORS EMBRACE EMERGING MARKETS?
Outside of the U.S., investors favored Developed Markets relative to Emerging Markets. Much of this may be attributed to the negative direction of the China-U.S. trade war along with the recent weakness of Emerging Market currencies. Developed Markets ETFs saw $3.48 billion more in net flows relative to Emerging Markets, taking in $1.76 billion in net new creations over the course of May.
The largest relative strength in flows throughout May across the five pairs was seen in U.S. exposure relative to International. Again, this was largely driven by outflows in U.S. Large Cap names, but this 1-month spread is quite notable. This past month was the largest relative strength in flows for International stocks over U.S. names since March 2018. We
would be remiss to fail to acknowledge the fact that, throughout the entire ETF industry, May has seen $20.94 billion in net outflows of equity exposure as investors have de-risked across many equity styles, sectors, and market segments.
FIGURE 4: ETF Flows Between Cyclical & Defensive Sectors Move Like Trade Tweets
Source: Bloomberg Finance, L.P., as of April 30, 2019.
WHERE ARE WE GOING?
TRUMP, TRADE, TARIFFS
Even with volatility increasing again in May, there remains disconnect, albeit a decreasing one, with economic data and market performance. Much of this may be attributed to the China-U.S. trade war dominating headlines and investor attention. Another reason market reaction may be more muted than expected is that the investment community actually
sees a path for an eventual deal to be rocky one, but ultimately a potentially constructive one for U.S. companies’ competitiveness. Of course, the challenging component is to understand whether tariffs are being used as a negotiation tactic or are part of a larger, more permanent plan that the President intends to implement.
INTEREST RATES: WHAT NOW?
The Federal Reserve seems to recognize the resiliency of the U.S. economy in the face of macro headwinds, making them reluctant to remain anything but data dependent. More specifically, the idea of taking out insurance cuts fails to capture the fact that rates never fully normalized to the extent that many expected. This is particularly acute in the context of the
Taylor Rule, which shows that the Fed was behind the ball. To be fair, this does not include other mechanisms, such as quantitative easing, that the Fed was using as part of their monetary policy. The bar will remain high for a cut even in the face of political pressure and the potential inflationary pressures that the recently increased tariffs could bring. Of course,
sustained contraction in economic growth or signs that weakness in inflation data is less transitory and more permanent would likely drive a cut. From a market perspective, a significant drop in the stock market or a spillover into credit, which so far has been benign could also cause action.
WHAT IT ALL MEANS. RELATIVELY SPEAKING.
Overall, we believe that investors need to remain on their toes in the coming months ahead as the path forward in 2019 may be increasingly detached from the still positive fundamentals. Specifically, even though absolute returns may continue to suffer, the U.S. remains favorable to International Developed Markets. Within the U.S., Large Caps, Growth stocks, and
Cyclical Sectors are positioned to remain in the driver’s seat thanks to their lean in quality bias with favorable earnings on a relative basis.
FIGURE 5: The Taylor Rule Implies That Rates Never Fully Normalized
Source: Bloomberg Finance, L.P., as of April 30, 2019. Data displayed is the Conference Board U.S. Leading Index Month-over-Month.
- 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.
- 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.
- 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.
- 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 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.
- 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.
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