We stay overweight cash and TIPS while maintaining our underweight allocation to equities, long-duration bonds, property, and private equity.
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- We stay overweight cash and TIPS while maintaining our underweight allocation to equities, long-duration bonds, property, and private equity.
- Within equities, we think Quality looks attractive as it provides exposure to companies with high profitability and strong balance sheets.
- S&P earnings forecasts show that analysts are no longer expecting a mild earnings recession this year, instead expecting earnings growth to re-accelerate from Q4. We would look to fade this view.
- Within fixed income, the interest rate market has all but priced out the cuts expected in 2023. However, as inflation continues to remain sticky, we still see value in cash and shorter-duration bonds.
Our Investment Views by Asset Class
What We Learned in May – Market Leadership Narrows
Market leadership has narrowed this year, with a small subset of stocks leading the rally in the S&P 500 since the banking crisis started in March.
Narrow breadth is consistent with a weaker equity market, and calls into question the durability of the recent rally. In May, the percentage of S&P 500 constituents above their 50-day moving average fell to 36% from 61% in April. Similarly, the percentage of members above their 200-day moving average fell to 44% from 59% in April (Chart 1).
This narrowing has coincided with the Citi economic surprise index falling over the last two months. This makes sense: we find market breadth correlates with economic growth. For instance, when growth accelerates, the market broadens as more stocks participate in the rally. Consequently, when growth decelerates or declines, market leadership tends to narrow (Chart 2).
We also looked at S&P factor performance in May and had three key takeaways.
- Factors without exposure to tech struggled as the AI theme exploded last month following Nvidia’s earnings release. Factors exposed to tech also saw the largest upward EPS revisions (Chart 3).
- Second, defensive sectors performed particularly poorly as the US 10Y yield rose by more than 25 basis points. We see this when looking at the ‘low volatility’ factor whose performance is mostly driven by the utilities and consumer staples sector.
- Finally, small caps continued their underperformance versus large caps for the third straight month, and that has been consistent across style tilts as well. This could be due to the banking crisis, with a reduction of loan growth from smaller and medium-sized banks most likely to impact SMEs rather than those firms who can easily access the capital markets.
In the short run, we expect market breadth to normalise, which should lead to both small caps and value outperforming. However, we think this rebound will be short-lived as the US economy continues to transition to slower growth, so we look to fade this move.
Why We Like Quality
We see three macro drivers of equities ahead:
- Economic growth slowing globally but staying positive throughout 2023.
- Potential for further rate hikes beyond what is priced as core inflation remains stickier than the Fed expects.
- SMEs could encounter increased challenges in accessing capital because of the banking crisis. The impact will be more pronounced in Europe where bank lending plays a bigger role.
Given this environment, the Quality factor provides exposure to attractive characteristics.
- Quality provides exposure to companies with greater profitability. For instance, the S&P 500 Quality Index has a return on equity (ROE) of nearly 30%, surpassing the 17% of the broader S&P 500. This elevated ROE is also consistent with superior operating margins.
- Quality offers stronger balance sheets. A focus on quality could help investors mitigate their exposure to companies more at risk from higher interest rates and further tightening of bank lending standards. Notably, the S&P 500 Quality Index has a net debt/EBITDA ratio of just 0.87, contrasting with the market average of 1.45. This disparity is particularly pronounced among small caps and value factors.
- Finally, relative to the growth factor, which also exhibits several of these characteristics due to the quality of the largest names in the index, the quality factor trades at a lower multiple and is on par with the broader market (Chart 6).
We looked more closely at how these factors performed recently. The higher valuation multiple associated with growth was consistent with a larger drawdown last year, when interest rates jumped (Chart 7). This aligns with the greater realised volatility observed over this period (Chart 8). Therefore, relative to growth, we believe exposure to quality is consistent with taking a relatively lower-risk position.
Going forward, we expect Quality to outperform as investors seek out companies who are profitable with strong balance sheets as economic growth decelerates. We also think Quality lets investors better participate in market rallies relative to Low Volatility, which is more defensive.
Markets Have Repriced Sharply Since March
As earnings season ends, we reflect on how earnings expectations have changed and consider what is now priced in over the coming quarters.
- At the end of March, analysts expected Q1 earnings for the S&P 500 to fall by almost 9% q/q or 8% y/y to $50.6 per share.
- However, earnings exceeded expectations at $54.4, with FactSet data showing that 78% of companies beat Q1 23 EPS forecasts – higher than the 10-year average of 73%.
- Also, fewer companies mentioned the word ‘recession’ during their earnings call, with 107 mentions in Q1 vs 147 in Q4.
Better-than-expected Q1 resulted in 2023 EPS estimates rising from $212 at the end of March to $221 at the end of May (Chart 9). However, as Q1 earnings were revised higher, earnings for the remaining quarters this year were revised lower as companies remain cautious (Charts 10 and 11). Meanwhile, earnings estimates for 2024 also rose from $234.8 in March (+10% y/y) to $239.9 a share (+8% y/y).
The shift in the earnings outlook shows near-term soft-landing concerns have been priced out, with quarterly earnings no longer expected to fall by 8% y/y in Q2 but by only 2%. Then, analysts expect earnings growth to re-accelerate into 2024.
In the short term, we think earnings expectations could still surprise to the upside given the relatively low expectation for Q2. This will be driven by elevated core inflation, which shows that companies continue to show pricing power helping to keep profit margins elevated.
Looking ahead, we remain cautious. Expectations for a sharper rebound on a y/y basis in Q4 2023 and Q1 2024 are at risk of disappointing, especially as the Fed continues to hike. Said differently, corporates being able to expand margins through their pricing power and therefore increase EPS would be inconsistent with the Fed’s goal of returning inflation to its target of 2%.
Consequently, we remain underweight equities over a 12-month horizon.
On the fixed-income side, our preference for short-duration treasuries and cash has served us well over the last couple of months as the market has begun to price out 2023 rate cuts.
Looking at the SOFR curve, the market has gone from pricing in almost 100bps of rate cuts by year-end in March to almost no rate cuts by the end of May. During this time, a short-duration exposure continued to provide both less sensitivity to changes in interest rates but also a higher yield due to the level of inversion in the curve.
For instance, T-bills currently yield more than 5%, which explains our max overweight position in cash, while 2Y treasuries yield 4.6%. Both options are more attractive to us than the 3.8-3.9% earned when going to 5-10 years along the treasury curve (Chart 12). We consider the potential to earn higher yields without needing to take on greater interest rate risk a gift to investors at a time when inflation will likely remain higher than the market expects even as growth continues to slow.
The situation is similar in IG credit where we are neutral. The IG curve is also inverted out to 5 years. But it re-steepens significantly beyond that due to the increased liquidity risk associated with IG credit out 10 years and further (Chart 13).
Given our view that interest rate risks are still skewed to the upside, we stay overweight cash and underweight longer-duration treasuries.
Last month, we highlighted that the negative correlation between US stocks and bonds had returned over the last three months, which meant bonds were again offering diversification benefits.
We now look at the relationship between global equities versus US inflation breakevens, nominal yields, and real yields. Over the last three months, as well as nominal yields, US equities are now no longer negatively correlated to real yields – therefore higher real yields are no longer pressuring equities lower. The correlation between 10Y real yields and the S&P 500 is now 0.34 from -0.3 over the last 12 months. In contrast, the correlation between US real yields and EM equities has remained fairly stable.
With respect to breakevens, we find that global equities (MSCI World) show the strongest correlation to the 5Y breakeven over the last three months. This relationship has strengthened over the last three months relative to last year. Again, EM equities, which have been driven more by the performance of Chinese equities and commodity prices, continue to be the least correlated.
Our Core Investment Themes
Our investment themes remain unchanged and continue to drive our core views. These are:
- The Economy Remains Stuck in a High Inflation Regime
- Terminal FFR Moving Much Higher
- Large Fiscal and Strong Consumption Keeps Growth Surprising to the Upside
What Is the Consensus Asset Allocation?
Fidelity Investments turned underweight US equities while shifting to neutral on Non-US DM equities. Underweight US aligns with our view but also looks to be a consensus position, with four of the six asset managers agreeing. We still disagree with the consensus among asset managers to move overweight US government bonds. Consensus looks to be too bearish on the prospects of US growth while underestimating inflation risks.