Fundamental momentum slowing for Cyclical sectors
For some time we have noted that traditional Cyclical and Value sectors have had much stronger earnings estimate revisions activity (“fundamental momentum”) than Growth or Defensive sectors. That has been changing recently as cyclical sector estimates are less strong than before, and Growth and Defensive are holding up better. Thus we have recently been looking more favorably on certain Growth or Defensive sectors and neutralizing exposure to Cyclical/Value areas.
What is stagflation and is it making a comeback?
A frequent question lately has been: are we currently in, or about to enter, a period of “stagflation” like the late 1960s and 1970s as a result of COVID and policy responses? Our short answer is no: while inflation may be elevated for a while, growth is currently strong, structural inflation pressures are low, and policy is better now than in the 1970s, making any sustained stagflation conditions unlikely. Below we offer some historical context and our current views.
Emerging Markets fundamental momentum still very weak
In our regional allocation work, we have been underweight in Emerging Markets relative to developed markets since May, and remain so currently. A key reason for our continued underweight stance is that the relative fundamental momentum for emerging markets remains very weak compared to that of the broader global equity market.
The chart below shows one of our popular composite indicator charts based on the relative performance of the widely-followed MSCI Emerging Markets ETF, ticker EEM, versus the broad global benchmark of the MSCI All-Country World Index (ACWI) ETF, represented by ticker ACWI.
Supportive and predictable policy helping keep equity volatility low
Major equity indices globally have been remarkably stable in recent months, pushing realized volatility readings to very low levels.
Our own research along with that of many others has shown that volatility in equities tends to be persistent in the shorter-term, while tending to mean-revert in the long-term.
Beyond the movements of a single index like the MSCI ACWI or S&P 500, we can also see that the average three-month volatility across a broad array of major developed markets individually is extremely low (chart below). This average of 18 countries’ volatility (based on their respective MSCI country equity benchmark index) is in the bottom decile of its 10-year range right now. This means that it is not just the dominant US market that has had low volatility, nor is it only the diversification effects that can dampen volatility in a broad global index, it is in fact a global pattern of low equity market volatility across many markets.
Market volatility vs Style volatility
Equity market volatility has been declining this year and has recently been below the long-run average. However, under the surface of the calm at the major index level, style rotation between Growth and Value has been extremely high.
The first chart below plots two rolling volatility series: the top section is the six-month annualized volatility of the S&P 500 index, while the bottom section is the volatility of the daily difference between the S&P 500 Pure Growth and Pure Value index returns. The dashed horizontal lines indicate the long-run average for each series.
Growth rebound looks extended, as do long-term bonds
We have heard a number of client questions about the recent rebound in Growth stocks relative to Value (or Cyclical) stocks, so here we review some of the recent price action and one of the key cross-asset drivers.
The first chart below plots the relative performance of the S&P 500 Pure Growth versus Pure Value indices (top section) along with the 14-day RSI technical indicator (bottom section) as a measure of overbought/oversold conditions.
Analyst uncertainty still high even as earnings estimates surge
As we have discussed for some time now, equity analysts are raising their forecasts for corporate earnings more broadly and by larger amounts than at any previous time in our 20-year data history. However, while analysts are confident earnings are rising, they still show significant uncertainty about the future level of earnings, as reflected in the dispersion or disagreement in estimates for US companies.
Cyclical sectors still have the fundamental momentum
One of the biggest questions we have been getting from clients is “is it time to rotate out of Cyclical/Value sectors toward Growth (or Defensive) sectors?”. Based on our measures of fundamental earnings momentum and macro views, our answer is “not yet”.
There has certainly been rotation in relative returns among Cyclical/Value and Growth sectors recently, along with worries about when the Fed or fiscal policy will shift to a less supportive stance. Our view is that corrections or consolidations after large gains (on an absolute or relative basis) are healthy and to be expected, and that is likely what we are seeing in the Value/Growth relative performance recently.
Sector Pair: Financials vs Health Care
In recent months, two of our strongest US sector allocation views have been to overweight Financials and underweight Health Care. A key feature of our sector work is that we often look at sector indicators on a “pairs” basis, i.e., the relative return, earnings momentum, and valuation of one sector versus another (as opposed to comparing sectors only to an overall benchmark like the S&P 500). This allows us to see the underlying relative performance drivers more clearly.
Inflation trend is still low
One of the biggest topics among investors recently has been inflation, particularly after the May Consumer Price Index (CPI) and Producer Price Index (PPI) reports (reflecting April data) that showed big monthly jumps in headline inflation: 0.8% for headline CPI and 0.6% for headline PPI. And the “core” rates that exclude food and energy were actually slightly higher than the headline rates in April.