We Still Like Our (Underwater) Positions!

Summary

• We review the performance of recent investment positions and update our views.
• In recent months, equities have traded in a narrow range, and several of our positions are modestly underperforming.
• However, underlying fundamentals are unchanged, and we maintain these positions or consider implementing them.

Market Implications

• Long high-yield ETF (HYG or JNK).
• Overweight growth, underweight value.
• Underweight banks, overweight SPY.
• Overweight homebuilders, underweight SPY.

In this note, we review the performance of various trades we have put on in recent months and update our views. Generally speaking, our positions are based on our assessment of ongoing macro trends rather than to capitalise on near-term technicals.

Long High-Yield Corporate Credit Risk

To capture interest income or carry in a low-yield environment, we favour high-yield corporate bonds. We can get exposure to the broad high-yield market through holding either the HYG or JNK ETF.

Credit spreads have ground tighter over the past year and settled in narrow trading ranges near decade tights (Chart 1a). The investment-grade spread is near 91bp; high yield is about 325bp. Therefore, our trade has eked out some gains. We expect spreads will stay near these levels and possibly gradually tighten further as long as the economy avoids a recession. Provided the economy is in growth mode (even if slow), corporate defaults will remain low.

We will probably see a wave of corporate bankruptcies in coming quarters as various loan and debt forbearance programs expire, but this will primarily affect smaller private companies. Investment-grade and high-yield companies with the heft to issue corporate bonds generally did not benefit from forbearance programs. Bottomline – some headline risk may exist, but defaults in the high-yield market will remain low.

While corporate bonds offer steady carry, investment grade in particular is subject to rate risk. Consequently, the investment ETF (LQD) is down about 5% on a total return basis since the beginning of 2021. We previously discussed how high yield is less prone than investment grade to rate risk, partly because higher carry offsets rising rates.

Note also in Chart 1b that corporate bonds are primarily a carry trade, with little capital gain upside. They do not offer the upside that equities do.

Growth Over Value

On 26 April, we went against the grain and positioned for growth equities over value. The trade promptly did poorly. In the S&P equity universe, growth underperformed value by about 6% across large-, mid-, and small-caps by mid-May (Chart 2). (The chart shows the price performance of growth ETFs divided by the price return of value ETFs. Table 1 summarises major sector ETFs). The catalyst was rising rates. Once the 10-year Treasury yield settled into a range, growth and value traded in a narrow range. The growth and value sectors of the Russell 2000 have performed similarly.

Near term, a combination of momentum and uncertainty about the pace of recovery and inflation may keep growth and value trading in this range or modestly favour value.

But medium term, if a solid recovery takes hold and the Fed upholds its commitment to keep rates low for the foreseeable future, we see growth reasserting its market leadership position.

We continue to position for growth ETFs over value ETFs, particularly in the large-cap sector.

Underweight Banks

On 28 May, we positioned for underweighting or shorting bank-oriented ETFs versus the S&P 500 ETF (SPY). Banks had a tremendous rally since the election, bringing them back in line with the pre-Covid S&P 500. So far, bank ETFs have traded in a narrow range versus SPY (Chart 3), outperforming SPY by about 0.5%. Therefore, our position is incurring a small loss. But we expect banks will underperform the broader market once Treasury yields break out of the current range, whether higher or lower.

Going forward, banks face various challenges. Loan growth has been depressed, and this will persist as long as the Fed continues its QE program. Apart from the largest, most banks simply lack the resources to invest in the kind of AI technology they will increasingly need to be competitive in coming years. Plus, they face rising competition from emerging fintech companies. And the Fed is now seriously studying how to issue a digital currency. While the Fed hardly intends to disintermediate banks, any digital currency will surely be highly disruptive to the current bank business model.

As with the growth trade, our underweight position for financials and banks in particular is a medium-term view, based on ongoing macro trends.

Overweight Homebuilders

On 28 May, we positioned overweight homebuilders given the strong demand for houses and a shortfall in the housing stock. To date, homebuilders have underperformed SPY by about 2.5%, and so our position is in the red. One reason is the May labour market report raised some concerns about the pace of the recovery. A second and perhaps more telling factor was a Fannie Mae homebuyer survey suggesting more people think it is a bad time to buy a house. A recent University of Michigan Consumer Sentiment Survey reported a similar trend.

However, these surveys are not saying that people do not want to buy houses – rather that they do, and they are discouraged because inventories are so tight.

We estimate that the housing stock is some 1-1.5mn units short of an optimal level – or roughly a year’s worth of building at current rates. Since current new supply roughly aligns with the annual growth in new households, the housing stock could take several years to ‘catch up’ assuming demand remains strong – as it likely will as long as mortgage rates remain low.

Essentially, homebuilders can build as fast as they can for the foreseeable future without much risk of overbuilding.

This should be an optimal environment for homebuilders and why we think they can outperform the SPY over the medium term.