It’s all about the election, right? But just for a moment, let’s look back at the month of October. Large-cap stocks fell, but U.S. bonds lost money too. Wait, mid- and small-cap stocks rose. So, was it risk-on or risk-off? And yes, we’ll get back to the election…
Perhaps what October told us was that there are two parts of the markets that might be a bit expensive. One may be U.S. large-cap stocks—more specifically, tech stocks. The S&P 500 tech sector fell roughly 10% for the months of September and October. And since tech now accounts for more than a quarter of the S&P 500, finger-pointing seems reasonable. The second expensive item may be U.S. Treasuries. Falling equities are often accompanied by U.S. Treasury rallies; but, with rates so low, how much lower could they go?
If large-cap tech stocks and U.S. Treasuries are a bit expensive, then October can be decoded as follows: An economic recovery—perhaps not in a straight line, and admittedly that faced some challenges—may have been sufficient to drive relatively inexpensive small- and mid-cap stocks and push up record-low U.S. Treasury yields.
So, back to the election. As we write this outlook the day after the polls closed, the Presidential election is up in the air, the Senate may remain in Republican hands, and the House in Democratic hands. A divided Washington may worry some that were hoping for an easy path to a big stimulus package. Economic indicators over the last several months, however, have been reasonably strong. The Institute for Supply Management (ISM) Manufacturing and Services surveys have been solidly in expansionary territory, retail sales were strong, and consumer confidence was strong. This happened precisely when many saw risks from the waning effects of the early pandemic stimulus. A divided Washington is, of course, less likely to implement substantial tax increases.
There’s still one big source of support for the economy and markets: The Fed. The election outcome does nothing to change the Fed’s long-term commitment to monetary stimulus. That support is a key driver of a continued economic expansion. Ongoing virus flare-ups may make for a sawtoothed recovery, but a recovery, nonetheless. And there is likely to be a vaccine sooner or later. More months like October—where areas of the equity markets that were left behind began to catch up, and record-low treasury rates crept up—may continue.
One important note to consider: Quality appears to matter again. Here, we define quality with indicators such as return on equity (ROE), which is the measure of a corporation's profitability made by looking at how much profit it generates with the money its shareholders have invested. The lowest-quality small caps, determined by having the lowest-quintile ROE in the Russell 2000, led in the rebound, but were left behind in October. Companies with higher returns on equity, stronger credit ratings, better margins, and consistent earnings and cash flows may be positioned to make the most out of such a sawtoothed recovery.
Mixed results in October.
Through the end of October, Q3 earnings season is two-thirds complete and is providing some positive news, perhaps catching up with better economic indicators. While the headline news on earnings will be centered around another sizable year-over-year decline (currently 9.8%), there are two primary reasons for optimism.
First, a near 10% decline is a marked improvement from Q2 results, where the decline was 32%. Second, and perhaps more importantly, a record number (86%) of S&P 500 companies are reporting results that are exceeding expectations. According to FactSet, this is the highest number since they started tracking the data in 2008. The large number of firms that have beaten expectations has had the welcome effect of cutting the earnings decline by more than half since the end of September. The news has also been favorable on the revenue side, with just over 80% of firms reporting better-than-expected results, and year-over-year decline of just 2%.
Positive surprises on the revenue and earnings side should be, all things considered, a welcome bright spot during what was a negative month for most equity segments. That said, this time investors aren’t necessarily looking at it that way.
Companies that have missed their earnings expectations this quarter have seen their share prices drop by 5.6%, on average. That part isn’t surprising, but what’s more telling is investor reaction to positive earnings surprises. Normally, firms that report positive surprises see their shares increase during the two days before and after earnings announcements. However, during Q3, positive surprise firms have also declined, on average, by 1.7%, according to FactSet.
Perhaps investor reaction to favorable earnings has been muted due to the uncertainty surrounding the election run-up. Or maybe it has more to do with skepticism around the durability of those earnings, the importance of which is highlighted as once-again increasing COVID-19 case counts bring more potential economic restrictions. Whatever the reason, it’s an important reminder to investors of the importance of focusing on companies with earnings resiliency during days like these.
We have previously written on small-cap companies’ propensities to outperform large caps after large market drawdowns, similar to what we experienced during Q1. Thus far in 2020, history is playing true to form. Since the market low on March 23, and through October 31, small caps have outperformed large caps, 54.7% vs. 47.7%. But, rather quietly, so have mid caps, which are often called the “forgotten asset class.” They have also done very well by returning 57.5% over the same period and are ahead of large caps. And for investors focused on earnings resiliency, consider this: mid-cap earnings during Q3 have held up better than large caps. Better still have been the S&P MidCap 400® Dividend Aristocrats®, a group of 50 companies that have grown their dividends for at least 15 consecutive years. Yielding 2.8% as of October 31, the S&P MidCap 400 Dividend Aristocrats offer an intriguing way to play the potential continuation of the mid-cap rally.
With both the S&P 500 and the aggregate U.S. bond market negative for the month, it may come as a surprise that high yield bonds managed to generate positive returns. High yield, or junk, bonds have historically had a higher correlation to equities than their investment grade counterparts. Did we see a unique phenomenon develop in October?
High yield bonds have more credit risk than investment grade bonds. They also happen to have less interest rate risk. The current duration of the investment grade bond market is more than double that of high yield (8.6 versus 3.8 respectively). And, while the duration of the high yield bond market is at precisely its five-year average, the duration of investment grade bonds has been on a fairly continuous uptick since 2015.
During the month, we saw long-term rates rise while short-term rates barely budged. It’s a trend that began during the third quarter, with the 10-year Treasury yield now having risen 20 basis points (bps) since June 30.
The differences in duration, and the steepening of the yield curve, hit investment grade bonds hard. While credit spreads for investment grade bonds actually tightened 3 bps more than high yield spreads during the month, higher interest rate sensitivity ate away at the return potential for higher-rated bonds, leaving investment grade bonds in the red, while high yield bonds remained in the green.
A “blue wave”-sized stimulus package is not needed for interest rates to rise at least modestly from today’s near-record-low levels. And, as the month of October demonstrated, interest rate risk is at least as important a driver of bond market risk as credit risk.
It makes sense for investors to consider corporate bonds whose additional yields look particularly inviting these days. However, particularly for investment grade bonds, investors may want to think about interest rate-hedged options, such as the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index.
The recent performance of rate-hedged strategies has been favorable, with the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index outperforming the broader investment grade bond market by 2.4% since June 30. Let’s take a look back at the last time the 10-year Treasury yield rose for an extended period—from July 8, 2016, through November 8, 2018. During this period, the 10-year Treasury Yield rose a total of 188 bps, and the investment grade treasury rate-hedged bond market rallied an impressive 12.55%. Meanwhile, traditional investment grade bonds fell 0.49%. The short-term corporate bond market, which is often used by investors to prepare for rising rates, rallied just 1.97%. As it stands now, the 10-year Treasury yield remains near historic lows, with likely much more room to go up than down.
Aggregate U.S. Bond market tracked by the Bloomberg Barclays US Agg Bond Index. High yield bonds tracked by the Bloomberg Barclays US Corp High Yield Index. Broader investment grade bond market tracked by the Bloomberg Barclays US Corporate Bond Index. Investment grade treasury rate-hedged bond market tracked by the FTSE Corporate Investment-Grade (Treasury Rate-Hedged) Index. Short-term corporate bond market as tracked by the Bloomberg Barclays US Corporate 1-5 Year Index. Source for data: Bloomberg.
Sources for data and statistics: Bloomberg, FactSet and ProShares
The different market segments represented in the chart use the following indexes: U.S. Large Cap: S&P 500 TR; U.S. 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.
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