As we enter the second quarter of 2019, a few key themes have emerged in our late-stage economic cycle. In this latest edition of Charting the Market, we're going to focus on five areas—the yield curve, the environment for active management in US equities, the factor landscape, earnings across sectors, and bond market opportunities.
Chart #1: Yield curve inversion doesn’t mean the sky is falling (yet)
The yield curve inverted for the first time since 2007 in March, as long-term rates dropped on dovish central bank meetings and slowing growth outlooks. Historically, an inversion has preceded economic recession and market downturns in the US, so many investors view it as a signal that economic growth will turn south in the near future.
However, as shown below the effect isn’t always immediate, and the market often continues to post positive returns in the months following a yield curve inversion. And even over the longer-term on average returns remain positive, albeit to a lesser degree.
Source: Bloomberg Finance L.P., as of 03/29/2019. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees of expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Performance returns for periods less than one year are not annualized.
My take: While an inverted curve can be predictive of a recession, it doesn’t necessarily mean the sky is falling today, it just means growth is slowing, and that long-term rates are below short-term rates. These are both indicators that we’re nearing the end of the market cycle—not that vastly negative returns are on the near-term horizon.
Chart #2: Small cap active management is having a moment
It’s now time for our quarterly revisit to the active environment barometer chart. As a reminder, the two metrics we commonly look at to see when the market environment is constructive for active management are dispersion and correlations. Active managers tend to outperform in periods of higher dispersion and lower correlations, as this is a time when stock-specific risks are more pronounced and there’s greater opportunity for security selection.
As shown below, this environment has been improving for active managers in the small cap US equity space, but not to the same degree in the large cap space. The second chart demonstrates that this has hindered the outperformance of active managers in Q1.
My take: Small cap managers in 2019 have begun to significantly outperform their respective benchmarks. The ratios have increased from prior years, and there appear to be more alpha-generating opportunities within small cap. If investors have a small cap active manager that’s underperforming despite this favorable environment, it might be time for some added due diligence.
Chart #3: Quality continues on its upward trajectory
If we pivot to US factor trends, we can see that quality continued on its upward trajectory in March, with performance ranking the top among all factors on a 3-month basis. Conversely, value continued rolling over and extended its underperformance trailing 12 months, and the size factor has started to reverse course and also trend south.
Source: Bloomberg Finance L.P., as of 03/29/2019. Past performance is not a guarantee of future results. MSCI USA Minimum Volatility Index, MSCI USA Enhanced Value Index, MSCI USA Quality Index, MSCI USA Equal Weighted Index, MSCI USA High Dividend Yield Index, and MSCI USA Momentum Index were used above compared to the MSCI USA Index. Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
My take: Quality is extending its run as investors continue to focus on firms with quality balance sheets in this late-stage economic cycle. Value has historically underperformed at this stage in the cycle alongside a flattening yield curve, so its recent slump is consistent with this pattern. And size, as small-caps are more domestically oriented and economically sensitive, has begun its decline as a result of the deteriorating US growth outlook.
Chart #4: A stronger outlook for energy earnings
If we take a look at how analyst earnings estimates are trending across sectors, it’s clear that energy is the real rising star. As shown below, 1-month changes to the analyst estimates of 2019 earnings per share (EPS)—as indicated by the orange dot—are most prevalent for energy companies. These energy earnings upgrades have largely been a result of oil prices ballooning up to $60 per barrel.
My take: It’s important to note that these energy earnings estimates are coming off a very low bottom, and that earnings growth over the remainder of the year for this sector is still projected to be negative. Where we think we might see some more earnings upside is in health care, as the positive earnings sentiment around that sector has been more consistent.
Chart #5: The belly of the curve is the place to be
If we take a closer look at corporate bond market segments, we can see the impact of the flattening yield curve. It has improved the risk/return profiles of short duration segments, while investors haven’t been compensated for longer duration exposures.
My take: A flattening yield curve creates more opportunities on the short end to generate income without overextending on duration. There’s also potential in the middle of the curve, where investors could benefit from a shift lower in rates without too much duration extension and drawdown risks.
Earnings per share (EPS)
A profitability measure that is calculated by dividing a company’s net income by the number of shares outstanding.
MSCI USA Enhanced Value Weighted Index
The MSCI USA Enhanced Value Weighted Index captures large and mid-cap representation across the US equity markets exhibiting overall value style characteristics. The index is designed to represent the performance of securities that exhibit higher value characteristics relative to their peers within the corresponding GICS® sector.
MSCI USA Equal Weighted Index
The MSCI USA Equal Weighted Index represents an alternative weighting scheme to its market cap weighted parent index, the MSCI USA Index. At each quarterly rebalance date, all index constituents are weighted equally, effectively removing the influence of each constituent’s current price (high or low).
MSCI USA High Dividend Yield Index
The MSCI World High Dividend Yield Index is based on the MSCI USA Index, its parent index, and includes large and mid cap stocks. The index is designed to reflect the performance of equities in the parent index (excluding REITs) with higher dividend income and quality characteristics than average dividend yields that are both sustainable and persistent. The index also applies quality screens and reviews 12-month past performance to omit stocks with potentially deteriorating fundamentals that could force them to cut or reduce dividends.
MSCI USA Index
The MSCI World Index, which is part of The Modern Index Strategy, is a broad global equity benchmark that represents large and mid-cap equity performance across 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalization in each country and MSCI World benchmark does not offer exposure to emerging markets.
MSCI USA Minimum Volatility Index
The MSCI USA Minimum Volatility (USD) Index aims to reflect the performance characteristics of a minimum variance strategy applied to the MSCI large and mid cap equity universe. The index is calculated by optimizing the MSCI USA Index, its parent index, for the lowest absolute risk (within a given set of constraints). Historically, the index has shown lower beta and volatility characteristics relative to the MSCI World Index.
MSCI USA Momentum Index
The MSCI USA Momentum Index is based on MSCI USA Index, its parent index, which captures large and mid cap stocks of the US market. It is designed to reflect the performance of an equity momentum strategy by emphasizing stocks with high price momentum, while maintaining reasonably high trading liquidity, investment capacity and moderate index turnover.
MSCI USA Quality Index
The MSCI USA Quality Index is based on MSCI USA, its parent index. The index aims to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage.
A graph or line that plots the interest rates or yields of bonds with similar credit quality but different durations, typically from shortest to longest duration. When the yield curve is said to be flat, it means the difference in yields between bonds with shorter and longer durations is relatively narrow. When the yield curve is said to be steepened, it means the difference in yields between short term and long term bonds increases.