Last week, my colleague Michael Arone outlined the many factors contributing to this seemingly inexhaustible cycle. So where do we go from here, and what can investors consider for portfolio positioning for the rest of 2019?
Here’s a brief look at three strategies to consider:
1. Target quality, but don’t overpay
Stretched valuations and slowing growth depict a late cycle environment, but this doesn’t mean that investors should abandon equities. Focusing on quality stocks with reasonable valuations may mitigate the episodic microbursts of volatility typical of a late-cycle market.
Since 1990, there have been seven economic slowdowns, defined by a deceleration of the Leading Economic Index’s year-over-year growth rate (like what we have observed since November 2018). And during these seven identified economic slowdowns, equities generated an average cumulative return of 26%.1
In these periods, investors have tended to favor companies with strong balance sheets and stable profits, thus requiring a lower risk premium. From a factor perspective, Quality outperformed the broader market in six out of the seven economic slowdown periods identified above by an average of 6%. This outperformance was followed by Minimum Volatility, which outperformed the market in three of the periods. As shown in the chart below, these late-cycle performance trends have started to emerge in 2019, as Quality has dominated year-to-date factor performance.2
Source: Bloomberg Finance L.P., as of 05/06/2019. 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, MSCI USA Momentum Index, S&P High Yield Dividend Aristocrats and MSCI USA Factor Mix A-series Index were used to represent Min. Vol., Value, Quality, Size, Dividend, Momentum, Dividend Grower and Multifactor strategies. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Past performance is not a guarantee of future results.
While Quality has worked well, its valuations relative to the broader market have moved higher and are now at their highest level in five years.3 Therefore, focusing on inexpensive quality names may be more beneficial.
2. Let bonds be bonds
Slowing corporate profits, tight credit spreads and the most credit ratings downgrades relative to upgrades for US companies in a quarter since the start of 20164 define our late-cycle environment. Slow growth and tepid inflation have constrained the long end of the yield curve for the past two years, pushing term premiums vastly negative and to their lowest level since 1961.5 The Fed’s downward revised dot plot, resulting from its lowered growth and inflation assumptions, confirmed the market’s expectation for no interest rate hikes in 2019. And with unemployment at generational lows and the US nominal output gap as a percent of gross domestic product (GDP) running above zero since June 2018, a rate cut is also unlikely.
With a constrained long end and low probability for Fed actions to move the short end, the curve will likely stay flat, residing within the 10-20 basis point range it has traveled in since the Fed went on hold and started preaching patience. In fact, since January, the rolling 50-day moving average 10- to 2-year yield spread has held steady at either 16 or 17 basis points.
Source: Bloomberg Finance L.P., as of 05/06/2019.
Given the late cycle and flat curve, we favor active and shorter duration bond strategies that offer the potential for increased income and return without adding uncompensated duration or equity-like risks.
- SPDR Portfolio Short Term Corporate Bond ETF (SPSB)
- SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB)
- SPDR SSGA Ultra-Short-Term Bond ETF (ULST)
- SPDR DoubleLine® Total Return Tactical ETF (TOTL)
3. Tap growth potential in emerging markets
Doubling its share of the global economy in the past 25 years and projected to grow at an average annual rate 3.3 times faster than those of major advanced economies through 2024,6 the emerging market (EM) segment is too big to ignore. With US dollar strength likely to fade going into the end of the year and late-cycle dynamics potentially supporting commodity prices, a broad EM allocation may be appealing, especially with the currently attractive valuations.
Yet, given EM’s susceptibility to currency and commodity shocks and its higher beta to the global economic climate, targeting EM sub-segments that may be more resilient to headline risks from trade tensions, macroeconomic shocks and developed market deceleration could better capture the structural changes fueling higher growth rates.
In the wake of the slowdown in synchronized global growth, EM assets have fallen out of favor, underperforming the S&P 500® Index by nearly 10% last year. EM underperformance has been even starker over the past 10 years, lagging the Index by 240% on a cumulative basis. This underperformance has created attractive valuation opportunities in the region. Relative to the S&P 500, EM equities are now trading in the bottom quartile based on various price multiples, as shown below.
Source: FactSet, as of 05/07/2019. EM represented by MSCI Emerging Markets Index. Past performance is not a guarantee of future results.
In the long term, EM growth is going to be driven by increases in population and productivity. Citing rising incomes, a growing workforce and increased urbanization, the McKinsey Global Institute estimates that domestic consumption in emerging countries will increase from $12 trillion in 2010 to more than $30 trillion in 2025, as their share of world consumption grows from 32% to 47%. This is likely to trigger a shift toward consumption-led economic growth rather than the export-driven model that most investors associate with emerging economies.
- SPDR Portfolio Emerging Markets ETF (SPEM)
- SPDR S&P Emerging Markets Small Cap ETF (EWX)
- SPDR S&P China ETF (GXC)
- SPDR S&P Emerging Asia Pacific ETF (GMF)
If you want to read more about our investment themes for the rest of 2019, you can access the full 2019 Midyear Outlook, or watch a video where Michael Arone and I talk about the different market contributors to 2019's positive start, and what we might see next.
1SPDR Research Team calculation, as of 04/30/2019. Past performance is not a guarantee of future results. Economic expansion is defined as the LEI Index YoY changes are positive and the rate of change is increasing. There were seven expansionary phases in the analysis. The average cumulative return is 21%.
2Bloomberg Finance L.P., as of 05/07/2019.
3FactSet, as of 04/30/2019. Quality is represented by the MSCI USA Quality Factor. Valuations are based on price-to-book and forward price-to-earnings relative to the MSCI USA Index.
4“Corporate Credit Downgrades Outpace Upgrades by Most Since 2016,” Bloomberg Finance L.P., as of 04/01/2019.
5Bloomberg Finance L.P., as of 04/29/2019 based on the Adrian Crump & Moench 10-Year Treasury Term Premium.
6IMF World Economic Data, State Street Global Advisors, May 8, 2019.
A “quality” style of investing emphasizes companies with high returns, stable earnings, and low financial leverage. This style of investing is subject to the risk that the past performance of these companies does not continue or that the returns on “quality” equity securities are less than returns on other styles of investing or the overall stock market.
Bloomberg Barclays Intermediate US Corporate Index
A benchmark designed to measure the performance of US corporate bonds that have a maturity of greater than or equal to one year and less than 10 years.
Bloomberg Barclays US Corporate Bond Index
A fixed-income benchmark that measures the investment-grade, fixed-rate, taxable corporate bond market. Includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
A given security’s potential to lose value if a prevailing market trend suddenly changes. The term also refers to the specific financial amount of the “worst case” loss that that can occur in such a sudden shifts.
A specific decline in the stock market during a specific time period that is measured in percentage terms as a peak-to-trough move.
Gross Domestic Product (GDP)
The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
International Monetary Fund (IMF)
A global body created to coordinate exchange rates and financial relations around the planet with the general aim of promoting stability.
Leading Economic Index (LEI)
A composite of 10 economic components that are analyzed monthly to help foresee changes in the overall economy.
MSCI Emerging Markets Index
Index captures large and mid-cap representation across 23 emerging markets countries. With 834 constituents, covers approximately 85% of the free float-adjusted market capitalization in each country.
Price-to-Book Ratio (P/B Ratio)
A valuation metric that compares a company’s current share price against its book value, or the value of all its assets minus intangible assets and liabilities.
Price-to-Earnings Multiple (P/E Ratio)
A valuation metric that uses the ratio of the company’s current stock price versus its earnings per share.
Price to Sales Ratio (P/S)
The ratio of the price of a stock and the firms sales per share. A lower P/S indicates cheaper valuation.
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.
S&P High Yield Dividend Aristocrats Index
A benchmark designed to measure the performance of the highest dividend yielding S&P Composite 1500 Index constituents that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 consecutive years.
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.