Pandemic, Not Panic. Yet.
- The COVID-19 pandemic continues to impact people and economies around the world, with consumer and investor sentiment appearing to be the weakest we’ve seen in some time. The negative performance across almost all risk assets was the headline for the month of March, but we remain optimistic there are signs of improvement in the markets.
- With more economic and earnings-related data on the way, investors appear to be cautious about the near-term market environment. The U.S. was a relative outperformer against international exposures, and growth continues to be resilient throughout this drawdown. The 1-month differential between high and low quality companies was stark, and small caps continue to be under pressure.
- Relative flows appear to be directly tied to relative market leaders. The U.S. equity market continues to garner inflows relative to their international counterparts, and while investors seem to be avoiding riskier segments of the market, both growth and value saw strong inflows in March.
In case investors had not had enough to think about in the first two months of this new decade, March brought the quickest ever bear market from all-time highs, as the impact of the COVID-19 pandemic created significant volatility across global markets. March 2020 will be remembered as the most volatile month on record, and Q1 2020 as one of the worst performing for many indexes around the globe. In addition to the concerns about one’s health, portfolios have had a diversification shock with the majority of assets, including traditional safe havens like gold, showing signs of weakness and selling off along with stocks.
The reality is the economy had been slowing prior to this, but the adjustment has been sharp due to the necessary implementation of policies to prevent further community spread. Jobless claims for the week ending March 21 of 3.28 million was off the charts, as the impact of the virus hit many industries extremely hard. Further, we have seen serious liquidity challenges across funding markets, bonds and even futures. In short, this environment has been downright challenging.
The U.S. economy has been a very consumer centric leading into this drawdown. With consumer spending and consumption being a core driver of economic activity, the scale of the contraction will likely be considerable due to worries over the virus and social distancing policies. The Federal Government is clearly concerned about the historic rise in jobless claims and unemployment, and while they seem to be taking historic measures to support consumers and small businesses during this time, it will likely be a longer timeline than most expect to achieve an environment that feels “normal” again.
On the positive side, while the numbers around coronavirus cases here in the U.S. and around the globe continue to rise, we’re starting to see some slowing in new cases and casualties in some major areas, such as Italy and Spain. As it relates to markets, the monetary and fiscal stimulus has been aggressive with trillions of dollars pumped into the system already, and more likely to come. The Federal Reserve’s balance sheet now stands at over $5 trillion, as it embraces a “whatever it takes” approach to this crisis. As noted last month, financial conditions have started to tighten, and deteriorated significantly in March, with credit spreads widening along the way.
Figure 1: Volatility has Been Extreme, and Credit Spreads have Widened
Source: Bloomberg Finance, L.P., as of March 31, 2020. The data represents the CBOE VIX Index and the BarCap U.S. High Yield Yield-to-Worst/10-Year Treasury Spread. Index descriptions presented under Definitions below. Past performance is not indicative of future results. One cannot invest directly in an index.
No market around the globe was spared in March, with all 49 countries in the MSCI ACWI having negative returns. Relative to major economic peers in Southeast Asia, the U.S. was an underperformer through the month of March, with the S&P 500 falling 12.35%, versus 6.59% in China and 7.15% in Japan. Relative to equity markets in other major economies like Germany, the United Kingdom, and India, however, the U.S. drawdown seemed somewhat muted. On the whole, developed markets actually eked out a modest gain relative to emerging markets last month, and despite the relative leadership via China and Japan, the U.S. outperformed the MSCI ACWI ex-US index.
Figure 2: Most Asset Classes Suffered Notable Drawdowns in March 2020
Source: Bloomberg Finance, L.P., as of March 31, 2020. The performance figures are indicative of benchmark returns throughout the month of March. U.S. 20+ Year is represented by the ICE U.S. Treasury 20+ Year TR Index, the U.S. 7-10 Year is represented by the ICE U.S. Treasury 7-10 Year TR Index, Gold is represented by the Generic 1st Gold Futures Index, U.S. dollar is represented by the U.S. Dollar Index Spot Rate, U.S. Aggregate Bond is represented by the Bloomberg Barclays U.S. Aggregate Total Return Index, MSCI U.S. Defensives is represented by the MSCI USA Defensive Sectors Index, Russell 1000 Growth is represented by the Russell 1000 Growth Index, the MSCI ACWI is represented by the MSCI ACWI Net Total Return Index, the MSCI U.S. Cyclicals is represented by the MSCI USA Cyclical Sectors Index, the Russell 1000 Value is represented by the Russell 1000 Value Index, and Oil is represented by the Generic 1st Oil Futures Index. Index descriptions presented under Definitions below. Past performance is not indicative of future results. One cannot directly invest in an index.
Within the U.S., investors favored high quality companies relative to low quality ones, which is consistent with expectations of performance during a sell-off. It may or may not surprise investors, but the 100 highest quality companies in the S&P 500® Index outperformed the 100 lowest quality ones by over 10% in March*. Growth continued its strong performance relative to value stocks, and has shown some resiliency amidst this drawdown, outperforming the broader market by over 3% in March. Large caps outperformed small caps through March as well, and we believe the major driver of higher leverage and less stability in earnings (in general) will continue to put pressure on small caps and value stocks.
Within the sectors spectrum, cyclical sectors continued to lag the broader market as well as defensive sectors as investors continue to rush to safety. While the recent ISM Manufacturing and ISM New Orders indicators are considered “soft” data points, both provided sub-50 readings in addition to the most recent initial claims figures.† The ISM New Orders figure was especially weak at 42.2, and while the current environment makes economic data and earnings predictions impossibly difficult, we find cyclical sectors to be under severe pressure at the moment. In fact, outside of the Information Technology sector (which does maintain a significant weight in the broader MSCI U.S. Cyclical Sectors Index), all five other sectors notably under-performed the broader market, with Financials the major laggard. Given the macro economic environment, and the anticipation for economic data and revenues and earnings to be materially lower in the near term, we anticipate relative out-performance to continue with the defensive sectors.
MONEY IN MOTION
While both absolute and relative performance metrics are potentially more telling than flows for gaining a perspective on the current market environment, we continue to track ETF flows in order to gauge sentiment and positioning throughout the ETF ecosystem. That said, the major theme of absolute and relative flows into U.S. focused products over the prior twelve months has continued this calendar year, and in the month of March. Stretching back to April, 2019, U.S. Large Cap ETFs have pulled in over $42B in net creations, and we actually saw signs of some potential bottom-picking in March, where U.S. Large Cap ETFs saw $22.3B in net inflows. This activity in March brought the year-to-date figure into positive territory for the year, and the $22B was $20B more than we saw in U.S. small caps, and almost $27B more than what we saw in International focused ETFs.
When it comes to growth and value exposures, both equity styles saw positive flows throughout the month of March, and have accumulated a total of $5.94B and $2.01B in net inflows on the year so far. Surprisingly, investors favored value relative to growth in March, albeit slightly. Just like in the market cap spectrum, the bulk of these flows came in this prior month. The same cannot be said for cyclical sectors, however, as the month of March saw $5.04B pulled out of cyclical sector products, and products across the Financials sector saw $3.04B in net redemptions alone. The flows here seem acutely tied to relative performance and relative leaders in the market; defensive sectors saw $2.34B in net creation activity in March, bringing the year-to-date total up to $6.27B.
We continue to pay attention to the details underlying these flows, but it should be noted the second half of March actually saw some slowing of momentum, with U.S. Large Caps and Defensive sectors actually seeing slight outflows to close out the month. With volatility easing, relatively, and volumes coming down a bit, we anticipate investors are waiting to see how the situation around COVID-19 develops, and are looking towards more data releases, including the upcoming earnings season.
Figure 3: Relative Flows seem Acutely Tied to Relative Performance Leadership
Source: Bloomberg Finance, L.P., as of March 31, 2020. Data displays the difference in net flows of ETFs tracking the five pairs of equity segments relative to one another. Each equity segment is comprised of a group of ETFs that track indexes, which are representative of these broad exposures, covering both the broad domestic and broad international equity market segments found in the Definitions list below.
Due to the depths of uncertainty surrounding the extent of the contraction and its impact on corporate earnings, the likelihood of additional downside to stock prices remains high. Investors should not be fooled by the near-term rally as we have likely not yet hit the bottom, even as the Federal Reserve has gone all-in with their programs. Investors have become accustomed to swift recoveries, but this will likely not be the case as the re-opening of the economy, when it occurs, will be gradual and measured. The years of aggressive build-up in debt by both governments and corporations are starting to send ripple effects into the broader economy.
Perhaps the greatest risk to the economy is the massive fiscal and monetary stimulus have not been enough to offset the effects of the two-part slowdown. In other words, the package does not stimulate growth. The first part, broadly, is the immediate shock to supply and demand we are all now experiencing. The timeline for this period remains unclear. The second impact relates to the extent of the reopening, which may be modest, especially relative to what markets may be expecting.
While we, as investors and as people, are continuing to look for steps towards a better situation in regards to the coronavirus, a better playbook may be to start looking at China as they open their economy back up, and then Europe to see if they can mitigate quickly and begin to grow again. These nations and economies may give investors here in the U.S. the best clues as to what we may expect to see as we move past the heart of the battle against the virus. The U.S. was hit with the virus last and will not get healthy first as we have little insight into the robustness of any recovery at this point.
After such terrible performance, history does suggest future returns should be strong, but the shape of the recovery will likely drive asset prices. Multiples have come down considerably, but even compared to long-term historical averages, they represent anything but bargain bin prices and earnings estimates are as unclear as we’ve seen in a long time. Interestingly, safe havens have also suffered a bit through this drawdown due to deleveraging, and this may simply be setting up gold to perform exceptionally well as the Federal Reserve embarks on a seemingly unlimited cycle of QE and fiscal stimulus requires even greater amounts of debt issues. Within stocks, we think most investors will stay defensive and look for growth opportunities with strong balance sheets in order to build long-term positions.
Figure 4 highlights the current positioning of our quantitatively based Relative Weight Model. These views are recalibrated monthly based on composite measures of momentum and valuation. Compared to last month, our model remains overweight to Large Cap, Growth, and the U.S. Given the recent relative momentum in Defensive Sectors, the momentum composite between cyclical and defensive sectors has moved to neutral (previously still in favor of Cyclical Sectors), but the macro-economic environment leaves us overweight defensive.
Figure 4: Relative Weight Positioning
Source: Direxion, as of March 31, 2020.
- 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.
* The quality score of each stock is derived from its return-on-equity, accruals ratio and financial leverage ratio. Return on equity is as a company’s trailing 12-month earnings per share divided by its latest book value per share, which is included to help identify how profitable and efficient a firm may be. Accruals ratio is the change of a company’s net operating assets over the last year divided by its average operating assets over the last two years, which can help to determine whether a company has quality earnings. Financial leverage ratio is a company’s latest total debt divided by its book value, which can help to measure how safe and solvent a firm’s balance sheet may be.
† A PMI Index of more than 50 indicates expansion of the manufacturing segment of the economy in comparison with the previous month. A reading of 50 indicates no change. A reading below 50 suggests a contraction of the manufacturing sector.
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