This Has All Been Wonderful
- With positive risk appetite setting the tone, U.S. small caps and cyclical sectors have led the way in February and on the year. On the flip side, emerging markets took a breather in February.
- In contrast to January, investors added to U.S. large cap equity ETFs. They also continued to plow into emerging markets at the expense of international developed markets.
- Looking ahead, while economic uncertainty remains high, the cycle looks to continue rolling ahead, especially as weakening data has put the set path of interest rate normalization on hold.
The end to 2018 was a period that investors hoped they could leave behind, but thanks to global stocks posting their second best ever January to February return, it is safe to say that they are likely finding it wonderful again.1 Even in the face of slowing global economic growth and increased geopolitical uncertainty, equity-market volatility collapsed markedly as risk appetite increased. Like January, the interconnectedness of days of doubts and hope surrounding the China-U.S. trade talks and the path of the U.S. monetary policy continue to dominate headlines and set the tone of markets.
FIGURE 1: ECONOMIC POLICY UNCERTAINTY REMAINS NEAR ALL-TIME HIGHS
Source: Baker, Bloom, and Davis, as of February 28, 2019.
While still expanding, the JPMorgan Global Composite, Manufacturing, and Services Indexes all trended negatively over recent months and are now at levels not seen since 2016, indicating that economic output is growing, but slowing. Interestingly, output in the U.S. has remained relatively robust, despite the struggles seen outside of the U.S. In fact, slowing trade was a primary driver behind the IMF’s recent downgrade of global growth. Of course, the increasingly binary nature of a Brexit deal or no-deal has played a role along with the potential for financial conditions to tighten again. Regarding Brexit, it seems increasingly likely that the upcoming March 29 deadline will be postponed, as all parties involved continue to work on finding the right deal.
FIGURE 2: GLOBAL FINANCIAL CONDITIONS CONTINUE TO RECOVER
Source: Bloomberg Finance, L.P., as of February 28, 2019.
Relative Value Themes
All things considered, performance across well-known investment pairs reflects this complicated backdrop of slowing growth actually being viewed positively because it postpones or ends what was a relatively set path of interest policy normalization. In times of geopolitical uncertainty and slowing economic growth, one would expect emerging markets to suffer, but the recent FOMC dovishness and a flattish U.S. dollar has actually helped emerging and developed markets to perform inline on the year. In addition, U.S. small caps have found a continued bid from investors and are outperforming U.S. large caps by over 7% year-to-date. With investors expecting the Federal Reserve’s rate hike cycle to slow or even be on an extended pause, small caps have offered risk-seeking investors an opportunity, even in the face of weakening economic data.
Watching sector exposure shows that Information Technology has been a key driver behind cyclical sectors beating defensive sectors, U.S. growth outperforming U.S. value, and the U.S. besting international shares since the former in each pair sees Information Technology (IT) as the largest sector weight. IT is by far the largest sector at 30% of cyclicals index and an even larger 32% of growth. IT names comprise around 20% of U.S. stocks, but less than 7% of international.
FIGURE 3: CYCLICALS AND SMALL CAPS OUTPERFORMED IN FEBRUARY
Source: FTSE Russell, MSCI, as of February 28, 2019. 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. Past performance is not indicative of future results. One cannot invest directly in an index.
Relative Weight Winners & Losers
Looking at the performance of relative weight strategies that offer amplified exposure of one market segment to another shows that the performance of U.S. small cap companies relative to U.S. large cap companies generated the best returns over the last month thanks to an environment that saw small outperform large by 1.81% with a return of 6.46%. On the flip side, developed markets outperformed emerging markets by 2.16% in February leading to emerging markets relative to developed markets declining by 0.77%, which was the only relative weight strategy in the red on the month.
FIGURE 4: U.S. SMALL OVER LARGE GENERATED THE GREATEST RETURN LAST MONTH
Source: FTSE Russell, MSCI, as of February 28, 2019. Past performance is not indicative of future results. Data represented by the indices presented below under "Index Glossary" and "Definitions".
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, our U.S. Large Cap category only focuses 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 may have other intended investment goals, such as a style or factor tilt.
Unlike January, investors allocated to U.S. large cap ETFs, but continued to move away from small caps, resulting in a spread of over $6.6 billion. Notably, it seems that some gains are being taken off the table, as small caps have seen close to $930.2 million in redemptions even with year-to-date gains of 17.03%. Thanks to year-end positioning and tax-related outflows, large cap ETFs have seen $12.8 billion of outflows over the last three months. Over the last 12 months, however, small caps continue to lead large caps in flows by over $18 billion as the performance of large and small caps has been relatively flat over the last year with a difference of only 0.59%.
Even with U.S. growth stocks beating U.S. value stocks by 3.46% over the last year, investors have plowed into value funds as investors looked to time an eventual rebound into value. Last month bucked this trend, as investors trimmed positions in value ETFs, perhaps indicating fatigue with the lack of a rotation. Of course, one month does not make a trend, so we will continue monitoring.
Over the last month, cyclical sectors have captured nearly $2.93 billion more in net flows relative to defensive sectors, thanks to the $2.76 billion of inflows into real estate funds, even as financials continued to see outflows to the tune of $0.61 billion. Despite the recent performance, outflows from financials, technology and consumer discretionary ETFs continue to drag down cyclical sector flows across the last three, six and twelve months, as concerns about global growth and the potential for slowing earnings growth weighs on these names.
Outside of the U.S., investors have continued to move toward emerging markets and away from developed markets. The strength of recent positioning suggests that a real trend towards emerging markets may be occurring as flows longer than twelve months have largely leaned heavily towards developed markets and the U.S., but as always emerging flows can reverse course quickly as investors can exhibit tourist-like behavior.
FIGURE 5: 1-MONTH & 12-MONTH FLOWS (IN $ BILLIONS)
Source: Bloomberg Finance, L.P., as of February 28, 2019. Data represents the relative net flows of ETFs in the respective categories to another.
WHERE ARE WE GOING?
U.S. earnings season has now almost come to a conclusion with over 93% of the Russell 1000 and 70% of the Russell 2000 having reported as of February 28. Looking back to the Q4 2018 results, earnings upside surprise versus expectations was the lowest since Q4 2016. Revenue upside surprise versus expectations was higher than in Q3 2018, but revenue growth was the lowest over the last 5 quarters.
While investors will continue focusing on headline risks, the impact of corporate earnings may gain greater attention thanks to many pointing toward the potential for an upcoming earnings recession as Q1 2019 estimates are pointing to a contraction in EPS growth.
As noted earlier, the two most impactful storylines are tariffs and the Federal Reserve’s decision around their balance sheet and future rate hikes. For example, additional tariffs on automobiles will impact Germany, Japan and Korea. The March 1 deadline for tariff hikes (up to 25%) has been delayed, but pressure remains in the form of 10% tariffs on roughly half of what the U.S. imports from China, and similar tariffs exist on what the U.S. exports to China.
Rate pauses are not guaranteed, but we have come a long way since last fall, when the Federal Reserve had hinted that three more increases were possible throughout 2019. With regard to the balance sheet, the runoff is likely coming to an end in 2019. The anticipation around positive developments regarding trade and fiscal policy, and evidence of a slowing macro environment, have led to disconnect among market participants, economists, and the FOMC. Last, but certainly not least, we have yet another upcoming Brexit vote, the reality that Italy is in a recession and Germany may be close in entering one to consider.
Despite the fact that U.S. equity markets have returned, in just two months’ time, what many market participants were expecting for the entire year of 2019; positioning suggests two major themes - U.S. risk assets remain the place to be, especially considering the weakness in Europe, and there may still be some legs left to this expansionary cycle. Recent data may even be suggesting that China and the U.S. growth concerns may be bottoming.
In closing, while the macro backdrop appears to be more favorable, investors should pay attention to valuations as they have returned to levels seen prior to the recent selloff. To be fair, they have room to continue expanding to reach the highs seen in 2018, but the arguments made post-selloff no longer hold much water.
FIGURE 6: VALUATIONS HAVE RETURNED TO PRE-SELLOFF LEVELS
Source: FTSE Russell, MSCI, as of February 28, 2019. Valuations are defined by the price-to-sales ratio.
1 As measured by the total returns of the MSCI ACWI in U.S. dollars since January 2001. Source: Baker, Bloom, and Davis.
|U.S.||Russell 1000 Index|
|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|
|International||FTSE All-World ex US Index|
|Developed Markets||MSCI EAFE IMI|
|Emerging Markets||MSCI Emerging Markets IMI|
- 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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