The future remains profoundly uncertain, as we are still dealing with the first-order effects of the COVID-19 pandemic. And while uncertainty may prompt investors to take a defensive, high-quality approach in their portfolio’s core, relative value opportunities may emerge that can be expressed peripherally.
The pandemic has intensified the behavioral tendency of home bias — when investors favor domestic equities and ignore the potential benefits of diversifying into foreign equities.
Outflows into non-US-focused ETFs are at their worst point for any three-month period ever, with $34 billion coming out over the past 12 weeks. Meanwhile, inflows into US-focused strategies have increased, leading to a differential well above the historical 90th percentile.1 Commodity Futures Trading Commissions’ futures positioning data for asset managers reveals a similar trend. In 12 of the past 16 weeks, positioning has been reduced for emerging markets exposures, while managers have added to their US futures longs.2
That positioning is a byproduct of non-US exposures underperforming the US for 25 consecutive months3 — the fourth-longest stretch ever. This underperformance has also strengthened the valuation case. Multiples are more attractive outside the US, with developed ex-US and emerging market exposures both trading in the top 90th percentile — some in the 100th — across four valuation metrics relative to their 15-year history, as shown below.4
Trimming portfolios’ home bias by adding more foreign exposure is a contrarian call, but it could be an opportunity if the regime cycle changes and valuations become too cheap to ignore.
It appears that Asia Pacific, led by China, may rebound more quickly from the pandemic than Europe will. As the epicenter of the early COVID-19 outbreaks, China’s cases peaked in late February. And while the economic contraction5 was severe, recent data suggests an uptick in activity6 that could be a glimpse of what a global recovery may look like.
China is now outpacing broad US and EAFE benchmarks year-to-date, as well as outpacing them over the past one-, three-, and six-month periods. And based on a composite of momentum, China ranks first among major nations.7 However, even with those strong returns, valuations for China equities are not stretched. Each metric measured ranks above the 50th percentile relative to the US.8
Trade tensions pose a risk to this opportunity. However, given China’s global export presence, those risks could be offset by any uptick in demand from more nations starting to reopen. China, therefore, could be another venue to trim any home bias.
Seek Value in the Middle
Large over small, growth over value. Those are the trades that have worked ─ not just this year, but over the past few years. Large high-growth firms have grown in importance, and returns have followed. This disparity in performance has been particularly acute lately, however. If the year ended today, growth would outperform value by the greatest margin of any year since 1998.9 This strong performance has also led to heightened valuations. And this may present a relative value opportunity, as academic factor analysis has indicated that growth is at its most expensive level to value ever.
Framing this debate under more implementable aspects, however, leads to analyzing valuations of different long-only style exposures. Using a five-valuation composite10 to compare the valuations of large-, mid-, and small-cap core, growth and value exposures,11 we found that:
Plotted below, a higher Z-Score indicates that the asset in the numerator of the ratio is more expensive. As shown, based on our research of basic long-only style exposures, mid-cap value may be a more ideal opportunistic allocation for those seeking a value revival.
Inflation through traditional price index measures will likely rise, driven by low base effects in the short term, but it will be tame — if not weaker — against the deflationary headwinds of deleveraging, technology, and an aging global demographic. Near term, however, this presents a relative value opportunity for Treasury Inflation-Protected Securities (TIPS) over nominal Treasuries.
While this crisis is unprecedented, the policy responses are similar to those during prior risk events, and insights can be gleaned from the past. Following the GFC, inflation began increasing as a result of the stimulus measures — averaging 2.4% from 2009 until 2012 — after a demand-driven deflation shock that started in 2008. As a result, after the Global Financial Crisis, TIPS began to outpace nominal US Treasuries. From mid-2009 through 2012, TIPS outperformed nominals in 60% of the months by an average of 30 basis points.12 One could reasonably expect the same trend today — given the price tag of the monetary and fiscal stimulus designed to fuel an economic rebound.
US five-year breakeven inflation rates are currently low, at 80 basis points.13 If the recovery does take shape, inflation is likely to surpass that level and possibly lead to stronger relative returns for TIPS. And with Fed Chair Powell saying that there is “no limit” to what the central bank can do with its lending programs,14 policymakers may allow inflation to run above target before dialing it back down.
With manufacturing and industrial production experiencing nosedives this year, the potential remains for a near-term cyclical rebound. A global restructuring of supply chains, with a current focus on reshoring, may weigh on the outlook for broad commodities. Potential stimulus through infrastructure and capital investment will be critical to support cyclical commodities, such as industrial metals and energy, while trade deals and disputes will remain a focus in the agricultural sector.
In this environment, gold may continue to be commodities’ main outlier. The biggest macro factors for the price of gold are likely to remain in the metal’s favor: continued heightened risk regime, lower-for-longer real rates, and the potential for further fiscal spending weakening the outlook for key reserve currencies — particularly the US dollar. And strong demand for gold from the investment sector driven by these dynamics may continue to offset softness in gold’s cyclical demand (i.e., jewelry). As gold has historically provided key return and diversification benefits during periods of market stress — more so than traditional commodities15 — investors may want to consider a heightened relative allocation.
Although economic uncertainty and rocky growth projections may indicate taking a defensive, high-quality approach in the larger parts of a portfolio, relative value opportunities could emerge amid ongoing volatility. These funds may help investors strike a balance.
1 Bloomberg Finance L.P. as of 05/18/2020, calculations by SPDR Americas Research with monthly flow data from 2013 to 2020. The net differential is currently $70 billion.
2 CFTC, Bloomberg Finance L.P. as of 05/15/2020.
3 Bloomberg Finance L.P. as of 05/15/2020. Based on 1-year trailing returns.
4 Price-to-Sales, Price-to-Earnings, Price-to-Next-Twelve-month Earnings, and Price to Book based on data from FactSet as of 05/15/2020, calculations by SPDR Americas Research.
5 China manufacturing PMI fell to an all-time low of 35.7 in February and rebounded to above 50 in both March and April, per Bloomberg Finance L.P. as of 04/30/2020.
6 China manufacturing PMI rebounded to above 50 in both March and April, and economists forecast positive GDP growth for every remaining quarter in 2020 per Bloomberg Finance L.P. as of 04/30/2020.
7 A 3-1, 6-1, and 12-1 momentum score was utilized and ranked against major nations, such as the US, Japan, Germany, France, Canada, Russia, Brazil, and India.
8 Price-to-Sales, Price-to-Earnings, Price-to-Next-12-Month Earnings, and Price-to-Book based on data from FactSet as of 05/15/2020, calculations by SPDR Americas Research based on 15 years of data.
9 S&P 500 Growth is outperforming S&P 500 Value by 19%, only bested by the 28% in 1998.
10 Price-to-sales, Price-to-Earnings, Price-to-Next-12-Month-Earnings, Price-to-Book, and Enterprise value-to-EBITDA
11 Large cap as defined by S&P 500 Index, Mid Cap as defined as S&P 400 Index, and Small Cap as defined as S&P 600 Index. To determine large versus mid and large versus small, ratios of the fundamental metrics for Large Core, Large Value, Large Growth were compared with Mid Core, Mid Value, Mid Growth as well as Small Core, Small Value, Small Growth, respectively. To determine growth versus value, ratios of the fundamental metrics for Large Value, Mid Value, and Small Value were compared with Large Growth, Mid Growth, and Small Growth. Ratios were normalized by calculating a Z score for each. To calculate a composite score, every fundamental metric’s Z score was averaged together. If plotting above zero, the factor is expensive; if below, it is cheap.
12 Bloomberg Finance L.P. as of 05/15/2020, calculations by SPDR Americas Research.
13 Bloomberg Finance L.P. as of 05/15/2020.
14 CBS 60 Minutes May 17, 2020.
15 Gold’s trailing 10 year correlation to 60/40 stock-bond portfolio is 0.17, lower than both the BCOM and GSCI indices, which have a correlation of 0.56 and 0.59 respectively. Source: Bloomberg, State Street Global Advisors. Data from 5/31/2010 to 5/31/2020. BCOM = Bloomberg Commodity Total Return Index. GSCI = S&P GSCI Total Return Index. 60/40 Portfolio represented by 60% MSCI World Index and 40% Bloomberg Barclays US Aggregate Total Return Index. Past performance is not a guarantee of future results.
Basis Point (bps)
A unit of measure for interest rates, investment performance, pricing of investment services and other percentages in finance. One basis point is equal to one-hundredth of 1 percent, or 0.01%.
EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization
An approximate measure of a corporation’s operating cash flow that is used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
Enterprise Value Multiple
The relationship between the value of the total enterprise, including cash and debt to EBITDA (Earnings before interest, taxes, depreciation and amortization)
PMI, or Purchasing Managers Index
An indicator of the economic health of the manufacturing sector. The PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.
Share price divided by per share revenue.
Share price divided by earnings per share. Lower numbers indicate an ability to access greater amounts of earnings per dollar invested. A higher number indicates that a company's stock is overvalued.
Price-to-Book Ratio, or 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. The P/B is a ratio of investor sentiment on the value of a stock to its actual value according to the Generally Accepted Accounting Principles (GAAP). A high P/B means either that investors have overvalued the company, or that its accountants have undervalued it.
S&P MidCap 400 Index
Provides investors with a benchmark for mid-sized companies. The index covers over 7% of the U.S. equity market, and seeks to remain an accurate measure of mid-sized companies, reflecting the risk and return characteristics of the broader mid-cap universe on an ongoing basis.
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.
S&P SmallCap 600 Index
Market capitalization-weighted measure of the performance of small cap equities within the United States, with constituents required to demonstrate profitability prior to gaining initial inclusion.
The views expressed in this material are the views of Michael Arone and Matthew Bartolini through the period ended May 21, 2020 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA's express written consent.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions. Funds investing in a single sector may be subject to more volatility than funds investing in a diverse group of sectors.
Foreign (non-U.S.) securities may be subject to greater political, economic, environmental, credit and information risks. Foreign securities may be subject to higher volatility than U.S. securities, due to varying degrees of regulation and limited liquidity. These risks are magnified in emerging markets.
A “value” style of investing emphasizes undervalued companies with characteristics for improved valuations. This style of investing is subject to the risk that the valuations never improve or that the returns on “value” equity securities are less than returns on other styles of investing or the overall stock market.
Although subject to the risks of common stocks, low volatility stocks are seen as having a lower risk profile than the overall markets. However, a fund that invests in low volatility stocks may not produce investment exposure that has lower variability to changes in such stocks’ price levels.
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.
Investments in mid-sized companies may involve greater risks than those in larger, better known companies, but may be less volatile than investments in smaller companies.
Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress
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