As the 2019 global equity rally enters its third month, in this latest edition of Charting the Market I unpack five of my favorite charts for the month, looking at sentiment, sectors, rates, and credit, to frame our overall perspective on the markets, examing the sustainability of the rally.
Chart #1: The golden cross is still out of reach
There’s no question that global equity markets have seen a strong start to the year. However, calendar-based returns alone can be misleading, which is why it’s important to also consider the technical backdrop. If we look at the last price relative to 50-day or 200-day moving averages at February month end, we can see that 84% of all global equities were trading above their 50-day moving average. This positive uptrend has pushed many areas Relative Strength Index (RSI) indicator to be near the overbought territory of 70. Taken together, they indicate strong short-term performance amidst this snapback rally, however, in nearly all of these markets the 50-day average has yet to exceed the 200-day average, which would signify a “golden cross”—a more meaningful positive trend momentum indicator.
An RSI greater than 70 indicates being in overbought territory.
Source: Bloomberg Finance L.P., as of 02/28/2019. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Performance returns for periods of less than one year are not annualized. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
My take: While some technicals support the story of a strong 2019 global equity rally, what isn’t yet known is whether the next leg of the rally will be as strong as the first one. The reasons behind the fourth quarter 2018 sell-off—slowing economic momentum, slowing earnings, and geopolitical concerns—still largely persist. And until the 50-day average crosses over the 200-day average and the golden cross is reached, it may be premature to claim the market is back to full strength. Given that short-term levels are near overbought territory, future returns could be a bit choppy as the market takes a breather after a hot start to the year.All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
Chart #2: The market is rewarding quality
The quality factor has recently been in favor, which is evident when looking at recent return trends for various long-only quality indexes relative to the S&P 500. However, a breakdown of the Morgan Stanley Long/Short Quality Basket—which takes the top and bottom 15% of Russell 3000 stocks and ranks them by their quality metrics—demonstrates that the short basket (e.g., firms with poor quality metrics) has been a noticeable driver of returns within that gauge.
Source: Bloomberg Finance L.P., as of 02/28/2019. Past performance is not a guarantee of future results. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. All the index performance results referred to are provided exclusively for comparison purposes only. It should not be assumed that they represent the performance of any particular investment.
My take: The market is clearly favoring quality. More specifically, it is rewarding firms with strong balance sheets while deliberately sidestepping firms that could have poor balance sheet fundamentals—a concern in today’s late-cycle environment where funding pressures could weigh on profitability. Look for this trend to continue as growth is expected to remain slow, and in some cases negative, leading investors to potentially place a higher emphasis on the sustainability of firm cash flows and the quality of balance sheets (high return on equity, low leverage) in order to handle adverse market shocks due to episodic volatility (e.g., geopolitical tensions).
Chart #3: Are cyclical sectors en vogue?
As the markets rallied last month, we saw cyclical sectors outperform defensive sectors and break through their 200-day moving average, as evidenced by MSCI’s cyclical versus defensive return spread.
Source: Bloomberg Finance L.P., as of 02/29/2019. Past performance is not a guarantee of future results.
My take: It’s important to keep an eye on whether the market continues to favor cyclicals, which could be an indication of a more sustainable rally. On an individual sector level this perceived “risk-on” stance differs, as only real estate and utilities—both of which tend to be defensive, bond-like proxies—have 50-day averages above their 200-day averages. And cyclical segments such as materials, financials and energy have 50-day averages that are 6.5%, 6.2% and 11% below their 200-day levels. Additionally, as shown in a different slide in the chart pack, defensive areas like health care, utilities, and real estate rank in the top three based on a momentum composite score. So while the return spread pictured above has started a short-term upward trend, the data beneath the surface still indicates some caution, or defensive positioning. We’ll have to look for more signs of renewed investor risk appetite to give us confirmation that this rally has legs. But right now, defensive positioning still exists at the sector level, a notion supported by flow trends.
Chart #4: Is the Fed reshaping the yield curve?
The Federal Reserve’s (Fed) decision to take a more patient stance on raising interest rates changed the course of treasury yield curve. The US 2-year yield—impacted by monetary policy—stopped short of moving forward in a linear upward fashion. As a result, the spread between the 10-year and 2-year yield halted its downward trajectory and has moved sideways since the Fed announcement. This has led some to ponder if the yield curve will start to steepen.
Source: Bloomberg Finance L.P., as of 02/28/2019. Past performance is not a guarantee of future results.
My take: Term premiums are still vastly negative which has, and will keep, long-term yields in check. Term premiums are reflective of the market's expectations of both growth and inflation, both of which remain low and slow moving. For this reason, irrespective of any potential Fed actions in 2019, we believe the yield curve will remain flat, creating opportunities on the short end of the curve for income generation without needing to extend on duration.
Chart #5: Emerging market debt shows promise
Going back to 2000, the median differential between the high yield bond yield-to-worst and the emerging market debt yield-to-worst is at about 1.27. Right now, that difference is 1.09, indicating that EM debt is trading nearly on par with high yield debt—despite the fact that EM debt is 80% investment grade versus all speculative grade for high yield.
My take: With yield differentials between emerging market debt and high yield bonds below their historical median, a relative value opportunity exists for investors who are seeking income without overextending on credit risk by allocating to emerging market debt in lieu of fixed-rate high yield. An emerging market debt position may introduce sovereign and currency risk. However, a continued patient stance from the Fed and a docile dollar, as shown by implied currency volality sitting near three-year lows, may alleviate some of those concerns.
Federal Funds Rate
The interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight.
A candlestick pattern that is a bullish signal in which a relatively short-term moving average crosses above a long-term moving average
MSCI USA Cyclical Sectors-Defensive Sectors Return Spread Index
The index aims to represent the performance of a strategy based on the return spread between a long position on constituents of one underlying component Index (MSCI USA Cyclical Sectors Index) while taking a short position on constituents of another component Index (MSCI USA Defensive Sectors Index).
Morgan Stanley Quality Long/Short Basket
A custom index that represents an equal notional pair trade of going long the US Quality Long and Short the US Quality Short basket. Performance reflects each side rebalanced back to equal notional at the close of each trading day.
Relative Strength Index (RSI)
A technical indicator used in the analysis of financial markets. It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period. The indicator should not be confused with relative strength.
Russell 3000® Index
A capitalization-weighted equities benchmark that is designed to be reflect the entire US stock market. The index measures performance of the 3,000 US public companies and represents about 98% of the market cap of US stocks. It is a composite index that combines the Russell 1000® Index of large-cap US stocks as well as the Russell 2000® Index of small-cap US stocks.
S&P 500 Index
A popular benchmark for U.S. large-cap equities that includes 500 companies from leading industries and captures approximately 80% coverage of available market capitalization.
The term premium is the excess yield that investors require to commit to holding a long-term bond instead of a series of shorter-term bonds.
The income produced by an investment, typically calculated as the interest received annually divided by the investment’s price.
Yield to Worst
An estimate of the lowest yield that you can expect to earn from a bond when holding to maturity, absent a default. It is a measure that is used in place of yield to maturity with callable bonds.