Look for Relative Value Opportunities Chaotic markets can create deviations from the norm across asset classes.
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.
Trim the Home Bias
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.
Watch China’s Rebound
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:
- Large cap is more expensive than mid and small caps
- Growth is more expensive than value broadly
- Growth is expensive relative to value within large and mid caps, but not in small caps
- Large-cap value is more expensive than mid-cap value
- Mid-cap value is attractive relative to small-cap value
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.
Swap TIPS for nominal Treasuries
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.
Consider Gold
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.
Implementation Ideas
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.
Whether looking for core US exposures or trimming a core’s home bias with strategies that seek to track indexes that blend low volatility, quality and value exposures, consider:
For opportunistic allocations in asset classes and markets, consider: