In this July edition of Charting the Market, we’ll explore the latest data from our active manager monitor, factor trends at the sector level, and the dovish take toward fixed income’s impact on gold prices. Finally, we’ll tackle positive credit trends that are not being felt all the way down the credit rating spectrum and what that means for the current market sentiment.
Chart #1: Small caps win with stock dispersion up, correlations falling
The macroeconomic environment in the first half of 2019 has created a ripple effect that’s impacted various sections of the market quite differently. Take technology for example: semiconductor companies with major revenues from overseas have been hit hard by Chinese tariffs and Mexican trade tensions, while software firms have mostly been spared. However, dispersion between small and large caps and movements in correlations have pointed to a more singular story: alpha has been more abundant for active managers to harvest this year.
Dispersion for both large caps and small caps is trending above the 15-year median—and for active managers, that provides an environment that’s conducive to generating alpha as there are more opportunities to overweight high performers and underweight low performers. Combined with a pair-wise correlation of large and small caps that is tracking below its 15-year median, and today’s environment is particularly amenable for active management.
Source: FactSet, Morningstar, as of 06/30/2019. *The universe is based on Morningstar Category. The Cross-Sectional Dispersion is calculated as the standard deviation of daily returns of index constituents for one month. Average stock correlation is calculated as the average correlation of each pair of constituents in the index over one month. Characteristics are as of the date indicated and should not be relied upon as current thereafter.
My take: While we have a very macro-driven environment, the environment has picked clear winners and losers, allowing active managers to profit. Considering that 60% of small-cap and 40% of large-cap managers have outperformed their benchmarks, if your active manager is not, it might be time for due diligence to determine whether their performance speaks to a momentary hiccup or a longer-term trend.
Chart #2: Momentum rotates cyclical, minimum volatility shifts to value plays
Previously, momentum strategies have been more defensive, with a high exposure to the HealthCare sector. Recently, however, momentum has rebalanced, with higher Technology and Industrial Sector exposure than before due to strong performance this year. This rebalance will likely result in a decoupling of momentum and minimum volatility factors, as they had been more highly correlated in the past based on the defensive tone momentum took.
From a performance perspective, the big winner last month was value, up 2.5% relative to a broad market-cap-weighted exposure. Between Iran sanctions boosting oil prices and the long-awaited OPEC cuts, energy seemed to bolster this exposure. But the real driver might be the yield curve steepening. Given the sizeable exposure to financials and the fact that the steepening of the curve is typically an indicator of risk-on cyclical-driven market sentiment, this time period can be constructive for value as a factor.
My take: Changes in sector allocations can impact factor performance, leading to questions around whether or not smart beta strategies should be sector neutral. This highlights the importance of due diligence when analyzing smart beta strategies, particularly multi-factor, as there can be a sector bias depending on its construction.
Chart #3: Dovish trends should impact gold spot prices
Globally, the chances of rate cuts in 2019 have launched up to 90%, 85% and 80% in the US, Australia, and the eurozone, respectively. All this speaks to the fact that the world is more dovish—and when rates are declining when they’ve already been low, it is pushing investors to the corners of the market to find yield.
What does this mean for gold? Despite gold’s perception as a safe haven to mitigate risk, it doesn’t pay an income stream or a dividend. But now, given that over $12 trillion of sovereign debt has a negative yield, one could say that gold has a higher yield (even at zero) than specific sovereign debt wielded within portfolios to mitigate equity risk. Considering that, along with more idiosyncratic macro risk, and all of this has had a definitive impact on gold prices, sending the yellow metal above a 5-year resistance level.
Source: Bloomberg Finance L.P., as of 06/30/2019. Past performance is not a guarantee of future results
My take: In my estimation, the biggest fixed income story doesn’t relate so much to bonds as it does to gold. Keep an eye on how increases in negative-yielding debt relate to gold spot prices.
Chart #4: Higher-quality bonds leading credit rally
Often, when the Federal Reserve becomes more accommodative, allowing investors to refinance debt at lower rates, this sparks a “dash for trash.” However, today’s credit story is slightly different.
High yield bonds are up 9% in the first half of 2019, not surprisingly coinciding with the best first half of the year for high yield ETF fund flows ever. This is not on the back of CCC-rated bonds, but of BB and B rated bonds, which are up more than 10% year to date.
Investment Grade: AAA, AA, A, BBB. High Yield: BB, B, CCC & Lower
Source: Bloomberg Finance L.P., BofA Merrill Lynch, as of 06/30/2019. Performance of investment grade and high yield segments are represented by the BofAML indices. Past performance is not a guarantee of future results.
My take: The cautious optimism in the bond market speaks to our current late-cycle environment where investors are aware that credit standards have deteriorated and balance sheets are highly levered. As there might be a few cracks in the credit foundation, it may make sense to let bonds be bonds to mitigate equity risk within a portfolio.
The views expressed in this material are the views of Matthew Bartolini 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.
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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.
The values of debt securities may decrease as a result of many factors, including, by way of example, general market fluctuations; increases in interest rates; actual or perceived inability or unwillingness of issuers, guarantors or liquidity providers to make scheduled principal or interest payments; illiquidity in debt securities markets; and prepayments of principal, which often must be reinvested in obligations paying interest at lower rates.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Investments in small-sized companies may involve greater risks than in those of larger, better known companies.
Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.
Value stocks can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.
Because of their narrow focus, sector funds tend to be more volatile.
Commodities investing entail significant risk as commodity prices can be extremely volatile due to wide range of factors Bond funds contain interest rate risk (as interest rates rise bond prices usually fall); the risk of issuer default; issuer credit risk; liquidity risk; and inflation risk.