The first quarter was a rough one for risk assets, such as stocks and high yield credit. Market volatility reared its head, and after the stock market correction, stocks closed the quarter in negative territory. The S&P 500® Index reported a loss of 1.2%, marking the first negative period for the index since the third quarter of 2015. 1
But headline numbers, like gains or losses, don’t always capture the nuances behind the market’s movement, and the outlook is not as perilous as the first quarter’s rise in volatility would indicate. Leveraging our monthly Chart Pack, I provide detailed analysis below on five themes (and charts!), helping to put first-quarter market performance in perspective while providing insight into the trends driving the market as we enter the second quarter.
Chart #1: Recovering from stock market corrections
We have seen five stock market corrections since 2009, and those drawdowns are captured below. On average, the market has spent 137 days in a correction before fully recovering. If this average holds, the S&P 500 will not return to its pre-correction levels until August 17.
Source: Bloomberg Finance, L.P., as of 3/31/2018. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Will we hit this average recovery period?
The early days make the path a bit perilous. Since the first quarter stock market correction, we’ve seen erratic market volatility and uneven investor sentiment. The catalyst for elevated near-term risks are not fleeting, and one would expect the headline events—particularly related to politics and policy—to continue to percolate throughout the market. Yet, this doesn’t mean all hope is lost.
My take: Despite the sell-off and ensuing volatility, strong fundamentals support the equity market’s path to a potential August 17 reunion with pre-correction market levels, including:
- Coordinated global economic growth: According to Bloomberg Finance L.P., 100% of developed economies are expected to have positive GDP growth in 2018 and 2019. For emerging markets, 99% and 98% of economies are expected to have positive growth in 2018 and 2019, respectively. Coordinated positive global growth is supportive of a continued run-up in risk assets.
- Improving fundamentals: The sell-off means stock market valuations are more attractive and earnings expectations have improved. The price-to-earnings (P/E) ratio for the S&P 500 is now around 16.8, right at its 20-year median. That is down from a P/E of 20 right before the market correction.2 Global equity valuations have also receded and are now trading slightly above their historical median, adding to the notion of a constructive environment for risk assets where growth is positive and valuations are appealing.
Chart #2: Not much good news for active managers
Active managers are most likely to generate alpha when two market conditions exist: high dispersion and low correlations among stock returns. Speaking solely for the opportunity in US large caps, in today’s higher volatility environment correlations of S&P 500 stocks have increased precipitously above their 15-year median—while dispersion has declined, as shown below.3
Source: FactSet, as of 3/29/2018. Past performance is not a guarantee of future results. The Cross-Sectional Dispersion is calculated as the standard deviation of daily returns of index constituents for one month. Average stock correlation is calculated as the average correlation of each pair of constituents in the index over one month. Characteristics are as of the date indicated and should not be relied upon as current thereafter.
My take: 2018 has been a good year for active managers in aggregate; however, if March’s trends for correlations and dispersion persist, it may be indicate a challenging environment is on the horizon. And March’s trends did take a toll on performance. Bank of America Merrill Lynch data shows 57% of active core large-cap managers are outperforming their benchmark year to date, their best rate since 2009.4 However, in February and March, when volatility spiked and correlations increased while dispersion dropped, only about 46% and 47% of active managers outperformed their benchmarks, respectively. In March, the average manager underperformed by 40 basis points. We’ll continue tracking these trends in the second quarter and their impact on active manager performance.
Chart #3: The toll of high earnings expectations
Earnings sentiment has been a strong pillar of the bull market, and the bar for earnings expectations has been rising. As a result of the tax bill, the S&P 500 has seen a sizable increase in earnings-per-share estimates for the first quarter—setting the earnings bar even higher.
These expectations are captured in the chart below, on the left-hand side. But as estimates have risen, one must remember the intolerance investors have for companies that fail to make their numbers. The chart on the right demonstrates how companies that miss earnings expectations are being punished considerably, more so than companies that beat estimates.
3 Views Into Earnings Sentiment
Source: Bloomberg Finance, L.P., State Street Global Advisors, as of 3/31/2018. Based on Consensus Analyst Estimates compiled by FactSet. Characteristics are as of the date indicated and should not be relied upon as current thereafter. There is no guarantee that the estimates will be achieved.
My take: This will be one of the most important earnings seasons in recent memory. It is occurring a time when the market’s nerves are a bit frayed and expectations are elevated. If companies can’t jump over this higher bar, performance will suffer, as it has historically. This could curtail the market’s overall performance.
Heading into this earning seasons, it may be wise to focus on segments of the market that have shown the propensity to outperform analyst expectations. One such sector is technology, as shown in the chart above. Technology has led all other sectors in the average percentage of companies beating estimates (87%) over the past four quarters—some 13% more than the broader market.5
Yes, it’s true that technology stocks were a big driver of the market sell-off and a reason why momentum stocks waned at the end of March. Despite this, we are still constructive on tech stocks. Valuations are not supremely stretched, earnings and sales growth are surpassing market estimates, and the sector has a history of beating earnings estimates. Tech stocks could have the wind in their sails heading into earnings season.
Chart #4: LIBOR spreads on the rise
This year, one headline-making story has been the shift higher in overnight unsecured bank funding rates, notably LIBOR. The chart below shows this is not a result of financial stress. The chart tracks the cumulative 3-month issuance of Treasury Bills and the line chart shows the LIBOR OIS spread. This spread widening has coincided—and likely been influenced by—this rise in issuance for T-Bills to fund the increase in the US budget deficit.
My take: This is a technically driven phenomenon and not indicative of internal financial stress like it has been in the past. The second order effect has been an increase in the attractiveness of certain instruments. For instance, the increase in LIBOR’s spread is one reason we are very constructive on floating rate instruments, like floating rating notes and senior secured loans, for income generation. In this environment, floating rate structures can limit duration (investment grade floating rate notes carry a duration of 0.15 years as a result of quarterly resets6) but also provide income as coupons increase along with a rising LIBOR rate.
Source: US Treasury, Bloomberg Finance L.P., Barclays Research, as of 3/22/2018.
Chart #5: Opportunity emerging in high yield
In the first quarter, high yield sentiment turned decidedly bearish. Short interest in high-yield ETFs, shown in the top chart below, reached an all-time high of 18% in March as rising interest rates and headline risks drove fears over the segment’s fundamentals.
The bottom chart shows high yield ETF cumulative flows since November. Even though high yield ETFs notched their fifth consecutive month of outflows, outflows picked up in earnest around the start of 2018. This is when market volatility rose, but so did yields on this market segment.
Source: Bloomberg Finance, L.P., as of 3/31/2018.
My take: I would argue that negativity around the high yield asset class is overextended. With yields above 6% and a dearth of yield available in other segments of the market, investors may be drawn back to this asset class. In this case, I wouldn’t be surprised to see high yield ETFs post inflows in April, reversing the course of five consecutive months of outflows.
A bumpy but supportive environment for risk assets
Volatility has returned and the threat of headline risk overhangs the market. But supportive economic growth, more constructive valuations and increasing global earnings estimates are supportive of a continued run-up in risk assets. Just remember: the path forward might be bumpy as the market works to recover from the current market correction.
1Bloomberg Finance L.P., as of 3/31/2018
2Bloomberg Finance L.P., as of 4/10/2018
3FactSet, as of 3/29/2018
4"Equity and Quant Strategy: US Mutual Fund Performance Update: Best 1Q for funds since 2009”, Bank of America Merrill Lynch
5Bloomberg Finance L.P., State Street Global Advisors, as of 3/31/2018
6Bloomberg Finance L.P., as of 3/31/2018
A gauge of risk-adjusted outperformance relative to a benchmark.
Floating Rate Notes
Debt securities designed to protect investors against a rise in interest rates, but also carry lower yields than fixed notes of the same maturity. The interest rate for a floating rate note resets or adjusts periodically (normally on a daily, monthly, quarterly or semiannual basis by reference to a base lending rate).
A benchmark rate that some of the world’s leading banks charge each other for short-term loans. It stands for Intercontinental Exchange London Interbank Offered Rate and serves as the first step to calculating interest rates on various loans throughout the world.
S&P 500 Index
A popular benchmark for US large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
Overnight Index Swap (OIS) rate
The overnight Index Swap rate is calculated from contracts in which investors swap fixed-and floating-rate cash flows. It’s commonly used as proxies for where market see U.S. central bank policy headed at various points in the future
The income produced by an investment, typically calculated as the interest received annually divided by the investment’s price.