In the third act of Shakespeare’s seminal play, King Henry V utters, “Once more unto the breach, dear friends, once more.” The words are intended to motivate the king’s troops amid continuous assaults on the gaps of the city walls during the siege of Harfleur. The motivation was necessary, as the weary English forces were beaten back and unsure about their prospects for victory. To forge ahead, courage and steely resolve were essential.
With the standard 60/40 portfolio sitting on current year-to-date gains against a backdrop of an elevated risk regime,1 investors may need to find a similar steely resolve today. As summer turns to fall, global capital markets face five key risks:
The pandemic – COVID-19 cases continue to rise around the world, albeit more slowly, creating confusion and delaying any return to normalcy. In many parts of the world, the weather is starting to turn colder, and the pandemic will converge with flu season. However, not all pandemic risks are to the downside: There have been encouraging advances with regard to a potential vaccine and more robust testing.
The re-opening of schools – Whether online-only, hybrid, or in-person, back-to-school season amid the pandemic will be inherently disruptive, confusing, and lead to an array of potential risks. Pitfalls in this new abnormal range from increased case rates as people congregate more regularly to heightened stress and potential lack of productivity for parents juggling work while ensuring their children are able to learn.
Earnings season without the low bar – Sizeable second-quarter earnings surprises fueled gains over the last few months. In the S&P 500® Index, 84% of firms surprised to the upside by a magnitude of 23%,2 both record figures. The eye-popping results were made possible by a low bar: Second-quarter estimates were slashed 37%,3 also a record. Third-quarter earnings season is unlikely to have the same low bar, as estimates have actually improved by 3 percentage points since June.4 While still projecting a decline, without a vastly lowered bar and more data on post-pandemic operations, the price reaction from earnings season may not be the same. This environment isn’t confined to the US: Global earnings estimates haven’t been slashed to the same degree seen for the second quarter.5
Elevated valuations – US stocks have not been this richly valued since the dot-com era, and by some metrics (e.g., next twelve-month price-to-earnings ratio), stocks are trading at higher valuations than during the dot-com era.6 Overseas, valuations are more constructive; however, considering that US equities make up more than 50% of global benchmarks,7 the nosebleed multiples do not portend a great margin of safety if investors no longer wish to pay more than $26 for next year’s earnings.
The election – For the rest of 2020, the US election is the proverbial elephant (and donkey) in the room. Over the next few weeks, rhetoric will intensify as heightened social unrest can no longer be separated from any election discussion. During September, the election will likely produce more noise than actionable news. Following the debates, more tangible information about candidate platforms and polling behavior will become available. Typically, autumn seasons with elections are more volatile than non-election autumns, a trend likely to continue given the unorthodox nature of this election cycle.
Asset class ETF flows: Bond funds still gaining, though record streak ends For bond ETFs, the four-month streak of $20+ billion monthly inflows ended in August. As shown below, the asset class only took in $16 billion last month. Sizeable outflows from government funds dragged the segment lower, partially offsetting the strength in all other areas. Notably, the $16 billion figure is still above the five-year median for monthly flows of $10.5 billion.
Equity ETF flows remained somewhat constrained in August, even as the broader market rallied back to new all-time highs . The $17.3 billion inflow in August is below the five-year median figure of $20 billion. Flows into commodity funds continued to shine, led by precious metal exposures, including gold. In fact, while bond ETFs saw an end to their record streak, gold funds’ streak of more than $1 billion of monthly inflows continued in August. With an inflow of more than $2 billion last month, the record now stands at eight consecutive months.
There isn’t much to read into the sub-median equity flows for August, as the historical relationship between flows and returns is loose at best. However, the below-median flows combined with near-median trading volumes for equity ETFs and stocks in the S&P 500 in August do suggest a low-participation rally.8 This is further reinforced by low positioning in S&P 500 futures (sitting in the 12th percentile over the last five years), and high cash positions as defined by money market assets (sitting in the 92nd percentile over the last five years and just shy of the max level following the onset of the pandemic).9
Fixed income ETF flows: Strength across multiple segments Bond ETFs have now amassed $142 billion this year. This is roughly $13 billion shy of the 2019 record, indicating that 2020’s full-year figure will likely set a new record. If we extrapolate the current year-to-date totals with the historical five-year median flow figure, the estimated full-year 2020 tally would be $183 billion. If we were to take a more aggressive approach and use the 2020 median of $19 billion, the 2020 calendar year flows could reach $220 billion. Either way, the question isn’t whether the 2019 record will be broken but by how much.
Taking a closer look at fixed income ETF flows, we see that only one bond sector had outflows in August, and six out of the eleven sectors had more than $1 billion of inflows, as shown below. The persistence of the inflows is also strong, as the same seven segments (Aggregate, Inflation Protected, Mortgage-Backed, IG Corporate, High Yield, and Municipals) all had inflows on more than 80% of the days in the last one, two, and three months. Some sectors are well north of 90%, having inflows on almost every day in the last few months. While certain segments (Aggregate, IG Corporate, and High Yield) have led in a somewhat concentrated fashion, the strength throughout the bond ETF ecosystem is a larger reflection of increasing usage across many client dimensions leveraging an array of portfolio implementation use cases.
Sector-focused equity ETF flows: Investors favor cyclical segments over defensive In aggregate, sector-focused equity ETFs posted inflows greater than $4 billion last month, marking the seventh month in 2020 with positive flows. As shown below, cyclicals outpaced defensives last month. Put another way, recovery sectors (Consumer Discretionary, Materials, and Real Estate) outpaced recession sectors (Utilities, Health Care, and Consumer Staples) when using the definitions we outlined in our 2019 study . Technology-focused ETFs continued to receive inflows, gaining $1 billion in August, and still lead sector flows year-to-date.
Sector flows have followed returns, to a degree. Technology, Consumer Discretionary, and Industrial stocks all outperformed the S&P 500 in August, and these three sectors had the strongest flows. Beyond that, there is little connection, as returns in the Utilities sector were down on the month, but the segment produced inflows. Short interest noticeably declined in Utilities, so perhaps the inflows were related to short covering.
Overall, as the economy continues to re-open and be on the path to recovery, cyclical sectors are likely to benefit as consumption and industrial activity rebound closer to pre-pandemic levels. The one exception would be Real Estate: The sector has historically done well during recoveries, but the pattern isn’t poised to continue, given the ways in which the pandemic has upended trends in commercial real estate, i.e., less demand for office space given the rise of at-home work arrangements.
Flows into sector funds have topped $20 billion this year, at $24 billion, and that doesn’t include the $15 billion deposited into the nontraditional thematic ETFs Those NextGen Trends funds, after posting a record $3 billion in June and July, took in over $4 billion in August. Their flows were led by funds targeting broad-based innovation, as well as strategies focused on firms creating more renewable forms of power generation. The traditional and thematic flows reflects specific investor behavior trend in 2020 – harnessing elevated dispersion and discretely positioning sectors based on market trends rather than indiscriminately buying broad beta
Looking ahead, investors may need steely resolve As investors go once more unto the breach in a tumultuous 2020, fortitude may be necessary. Three potential tactics are worth considering as we forge ahead:
Diversification – Ensure portfolios are appropriately diversified with potential defensive positions, like gold, that may be able to parry any uptick in volatility.
Don’t panic – Nerves of steel may be required to avoid hasty changes to a strategic asset allocation mix. After all, some of the S&P 500’s best days have followed the worst.10
Focus on the future – COVID-19 has created a new trend line for our society, and new innovative growth opportunities have emerged that may help position us for our new reality.
1A mix of the MSCI ACWI Index and the Bloomberg Barclays US Aggregate Bond Index is up 5.8% year-to-date as of 8/31/2020, per Bloomberg Finance L.P. 2FactSet as of 8/31/2020 3FactSet as of 8/31/2020 4FactSet as of 8/31/2020 5FactSet as of 8/31/2020 6Next twelve-month price-to-earnings ratio is at 26.83, higher than the level 26.4 level in 1999, FactSet as of 8/31/2020 7Based on the MSCI ACWI IMI Index per Bloomberg Finance L.P. as of 8/31/2020 8Trading volumes for August are sitting at the historical median, per Bloomberg Finance L.P. as of 8/31/2020 9Bloomberg Finance L.P. as of 8/31/2020 10“Miss the Worst Days, Miss the Best Days”, Michael Batnick 2019, https://theirrelevantinvestor.com/2019/02/08/miss-the-worst-days-miss-the-best-days/
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