It’s 2021: Where’s the clarity? While political unrest and pockets of unusual market activity grabbed the headlines, the market’s trajectory—just as it appeared to be at the end of 2020—is still largely dependent on a pending economic recovery driven by the defeat of the pandemic. With vaccinations surpassing infections in the United States, we may be moving in the right direction. However, let’s turn our attention to the domestic economic data, which is not looking too bad.
The Congressional Budget Office (CBO) recently increased its forecast for GDP growth to 1.7% annually from 2020-2024. That’s a 0.7 percentage point increase from the previous expectation released in July, which was admittedly prior to the emergence of effective vaccines. But isn’t that the point?
There are other solid data points as well. January’s ISM Manufacturing PMI came in at 58.7. Anything above 50 is considered expansionary. It’s been over 50 since June. Some will shrug and say, sure, but what about services? That’s where the real trouble is. Well, the ISM Services PMI has been well above 50 since June as well.
Source: Bloomberg. Data represents 12/31/2014 to12/31/2020.
It’s highly likely that there will be some level of fiscal stimulus from Washington emerging in the coming weeks, but a key stimulant is likely to come from consumers themselves. As seen in the chart of the month, the U.S. personal savings rate (as a percent of disposable income) spiked in the early locked-down days of the pandemic, and has remained at roughly double pre-pandemic levels. Who hasn’t had the conversation with a friend regarding all the things they want to do “when all this is over”? Pent-up demand is another key reason why economic growth is likely poised to at least meet—if not exceed—expectations. And if economic growth meets or exceeds expectations, companies are likely to as well.
Small caps and emerging markets led the way in January.
“At some point” seems an obvious, yet unsatisfactory, response to one key question on many investors’ minds these days. Two data points from the market’s developments in January demonstrate a rather ironic dynamic at play. Point A is the fact that, according to Morningstar, in the midst of a raging pandemic, riskier stocks—or those with higher levels of beta—have outperformed lower volatility stocks. (We’ve represented high-beta stocks using the S&P 500 High Beta Index and low volatility stocks with the S&P 500 Low Volatility Index.) Last week, this was punctuated by a disproportionate share of market attention being cast upon huge price rallies in a relatively small number of heavily shorted stocks with poor fundamentals.
Point B relates to Q4 earnings season. While it is still early and only roughly 40% complete through the end of January, results thus far have been promising. Yes, earnings will be down on a year-over-year basis, but they are better than analysts had hoped they would be. According to FactSet, over 80% of the S&P 500 companies that have reported results thus far have topped their earnings forecasts, and over 75% have surpassed revenue expectations. If these earnings trends continue, it will be the second highest rate of beats since the data has been tracked. While those results should—all else being equal—be well-received, the opposite is happening. The market is, in fact, punishing positive earnings surprises. Companies with positive earnings surprises have seen their shares decline by an average of 1.5%, far worse than the historical five-year average price increase of 0.9%.
Is this a case of expectations being too high—or perhaps, pockets of excessive risk-taking in hopes of identifying potential home-run returns against the backdrop of accommodative monetary and fiscal policy? What, exactly, is driving these anomalies remains unclear, but it does appear that, at least for now, fundamentals are being tossed aside like yesterday’s news. But sooner or later, fundamentals will matter again. They always have and always will, aside from brief departures.
Sometimes, as the saying goes, the best offense is a good defense. Despite exceptionally strong returns since the market lows in March, the CBOE Volatility Index (VIX) has remained stubbornly elevated (above 20) for an extended period, which is a rather unusual combination. It’s an indication that we are not out of the pandemic woods yet, and recovery remains just over the horizon. Perhaps now is the time to look for all-weather strategies that can “participate and defend,” with lower risk.
Two strategies we favor include the high-quality dividend growers of the S&P 500® Dividend Aristocrats® Index—which, as a whole, have demonstrated stable earnings, solid fundamentals, and strong histories of profit and growth—and essential, asset-based infrastructure, as represented by the Dow Jones Brookfield Global Infrastructure Composite Index. A common denominator between the two is relatively stable and resilient cash flows, suggesting that they could be the types of companies that can be held in any market environment. Over time, the characteristics of stable and resilient cash flows have led to asymmetrical upside and downside capture ratios, with lower levels of risk, as measured by beta.
The upside and downside capture ratios explain how an investment typically performs in relation to its benchmark index. An upside capture ratio over 100 indicates a fund has generally outperformed the benchmark during periods of positive returns for the benchmark. Meanwhile, a downside capture ratio of less than 100 indicates that a fund has lost less than its benchmark during periods of negative returns for the benchmark.
Source: Morningstar. Large-cap dividend growth stocks are measured by the S&P 500 Dividend Aristocrats Index 5/1/2005 to 1/31/2021 and global infrastructure is measured by the DJ Brookfield Global Infrastructure Composite 8/1/2008 to 1/31/2021.
With many attributing recent pockets of volatility in the equity markets to day traders, what is the bond market telling us? Irrational exuberance and emotional investing are phrases one may see used in tandem with stocks, but the fixed income market may provide closer insight into what the “smart money” is doing. This is not to say that bond investors are smarter than equity investors, but that the trends of bond investors have historically been stronger indicators of potential economic developments.
Let’s take a step back and look at what happened in 2020. The calendar-year performance of the S&P 500 rallied more than 18%, largely due to investor expectations around the reopening of the economy. Valuations expanded dramatically as prices rose, but earnings contracted. When we look at credit markets, while the corporate bond market posted impressive returns due to falling interest rates, credit spreads were fairly flat, year over year, indicating that bond investors’ risk appetites for credit were essentially the same as they were at the end of 2019.
Volatility is a risk metric that measures the dispersion of returns for a security or index.
While credit spreads may be in a similar place, corporate debt levels have continued to rise. In our 2021 Market Outlook, we took a look at national debt levels relative to GDP, and the story behind corporate debt is more of the same, with corporate debt levels near all-time highs.
Source: Federal Reserve Bank of St. Louis.
Should we be ringing an alarm? Corporations have been taking on debt in order to take advantage of low interest rates, allowing them to finance business initiatives. The idea here is that these increased debt levels will fund future growth. And with credit spreads in a similar place prior to the pandemic, perhaps the “smart money” is not all that concerned, either.
A potential cause for concern, however, is that the duration of the corporate bond market is near all-time highs, standing at 8.7 years for the Bloomberg Barclays US Corporate Bond Index as of the end of January. This indicates a potential loss of 8.7% if interest rates were to rise by one percent. To put things into perspective, while the yield curve has steepened over the past six months, the 10-year Treasury yield remains 94 basis points below its five-year average. So, while credit risk may be similar to where it stood a year ago, interest rate risk is substantially higher as corporations have taken on additional debt with extended durations.
Duration is a measure of bond price sensitivity to a change in interest rates.
Sources for data and statistics: Bloomberg, FactSet, Morningstar, ProShares
The different market segments represented in the performance recap charts use the following indexes: US Large Cap: S&P 500 TR; US Large Cap Growth: S&P 500 Growth TR; U.S. Large Cap Value: S&P 500 Value TR; U.S. Mid Cap: S&P Mid Cap TR; U.S. Small Cap: Russell 2000 TR; International Developed Stocks: MSCI Daily TR NET EAFE; Emerging Markets Stocks: MSCI Daily TR Net Emerging Markets; Global Infrastructure: Dow Jones Brookfield Global Infrastructure Composite; Commodities: Bloomberg Commodity TR; U.S. Bonds: Bloomberg Barclays U.S. Aggregate; U.S. High Yield: Bloomberg Barclays Corporate High Yield; International Developed Bonds: Bloomberg Barclays Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced. The fixed income section uses the following indexes: The Aggregate U.S. Bond market is tracked by the Bloomberg Barclays US Agg Bond Index; high yield bonds are tracked by the Bloomberg Barclays US Corp High Yield Index; the broader investment-grade bond market tracked by the Bloomberg Barclays US Corporate Bond Index; the investment grade treasury rate-hedged bond market is tracked by the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index and the FTSE High Yield (Treasury Rate-Hedged) Index; the short-term corporate bond market is tracked by the Bloomberg Barclays US Corporate 1-5 Year Index.
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