What We are Hearing and Seeing 8/14/20
Diversification is Boring
The excitement and appeal of day trading has taken off since the U.S. lockdowns in March. The stay-at-home orders, combined with the lack of sports, zero-commission trading , and slick trading platforms like Robinhood have helped make day trading easily accessible….and fun. E* Trade Financial opened up 260,000 retail accounts in March, while Robinhood logged three million new accounts during the first quarter. With daily market headlines around the monumental returns within the technology and healthcare sectors, it is difficult for advisors and clients to stay focused on the big picture.
Facebook, Amazon, Apple, Microsoft, and Google now account for an astonishing 22% of the S&P 500 Index. As of the end of July, these stocks have returned 35% year-to-date, while the remaining 495 stocks in the S&P 500 are down 5%. These simple (although short-term) stats can easily steer clients away from their diversified portfolios.
Diversification is a long-term story. It isn’t exactly fun and exciting to talk about. It is, however, one of the foundations of investing and a time-tested, proven investment approach to achieving long-term investment success. A key hallmark of any well-performing investment portfolio has historically been, and will likely continue to be, diversification between asset classes. It takes patience and is usually not the topic of conversation at dinner parties, or rather, Zoom happy hours gatherings.
As strategist managers prepare their portfolios after the sharpest (and potentially briefest) recession on record, a majority of our multi-asset managers are balancing their portfolios around their neutral asset allocation targets. The uncertainty around the economic recovery and upcoming U.S. presidential election is driving their timid postures. A consistent overweight to U.S. and growth-oriented equities is present in most managers. Many expect value-oriented equites to remain out of favor but predict some short-term pops; an opportunity for the more active and tactical managers. Fixed income allocations are high quality and slightly lower duration relative to fixed income bogeys. Another common theme has been the discussion of fundamentals. We’ve heard loud and clear from our managers. Fundamentals matter. Maybe not now, but they matter over the long-term and investing is a long-term decision.
Most asset managers believe that it will be a gradual grind to get back to pre-COVID economic levels along with substantial risks along the way. The road to recovery will affect various regions and individual companies differently. As a result, most see the next 12-18 months as a ripe opportunity for active management within both equity and fixed income asset classes. The range of outcomes over the short-term remain extremely wide. One of simplest ways to approach these uncertainties is to stick to diversification. Not only diversification across asset classes, but also investment styles and investment strategy types. Taking a bet on one approach or style might be beneficial in the short-term, but diversifying across the board is typically the most appropriate way to achieving long-term investment success.
Global Restart - What to Look Forward To
Global equity markets staged a strong rebound during the second quarter, retracing much of the decline seen in March. Governments and central banks across the world responded swiftly by reducing interest rates and announcing fiscal and monetary stimulus. These measures have helped countries absorb the demand shock and drive markets higher.
Europe has rebounded nicely from the crisis after the initial hit and should be better prepared to deal with subsequent waves of infections. The impact of the pandemic and ability to withstand it varies greatly by country. The resulting dispersion offers opportunity for active managers. Germany’s economic activity levels have held-up better than the rest of Europe while Spain, Italy, and the UK have all suffered steeper declines. UK markets have lagged global peers, weighed down by the uncertainty over the post-Brexit trading relationship with the European Union. On a positive note, EU leaders reached an agreement on a $858 billion stimulus plan which can act as a catalyst for markets. A majority of our non-US equity managers believe Europe is well placed for a recovery because of its strong health infrastructure and its position to benefit from improvement in global trade.
Equities in emerging markets remain well below their year-end levels. As of end of second quarter, the MSCI Emerging Market Index was down close to 10% from the beginning of the year. Strong growth, solid balance sheets, and fiscal conservatism has long been the mainstay of emerging market investing. This allowed emerging markets to enter the crisis in stronger financial shape. However, economic activity remains stagnant and debt levels are on the rise. Emerging market economies are heterogeneous and their ability to respond to this crisis varies greatly by country. This makes country and security selection key going forward. Active managers believe that secular trends, like companies that operate internet platforms involved in consumer goods, video games and mobile cash transactions, will continue to drive opportunities.
Uncertainties Continue to Ebb Away from Emerging Debt Markets
After bearing the brunt of the impact of the first quarter market volatility, emerging markets (EM) debt bounced back in the second quarter fueled by the rapid, substantial monetary and fiscal stimulus announced by the world’s major economies. The $1.2 trillion hard currency sovereign debt markets, as represented by JP Morgan EMBI Global Diversified Index posted 12.26%, making it one of the best performing asset classes within the taxable fixed income space in the second quarter. Within EM debt, as expected, the safer investment grade external debt led the initial recovery. Once the rebound gathered steam in May, local currency debt started recouping their losses.
Active managers are keeping a close watch on the changing dynamics within emerging markets. In fact, Lazard Asset Management in its outlook highlighted that they started the first quarter with an investment grade focus, emphasizing countries with strong balance sheets while later rotated towards high yield during the second quarter. This was made on the viewpoint that valuations within high yield remain attractive and the segment would see additional spread tightening. Notably the spread differential between high yield and investment grade EM debt remains at a historically high (over 600 basis points). Historically, EM default rates have been lower than U.S. high-yield for 11 of the past 12 years. With economies reopening, PineBridge Investments has increased its allocation to emerging markets across their portfolios. While rating agencies have painted a gloomier picture by predicting up to 13.7% of EM corporate bonds of sub-investment grade may default, PMC Research believes it leads to further inefficiencies to exploit for active managers.
Another driving factor which may provide a boost to active EM managers is a weakening U.S. dollar. Large liquidity injections by the U.S. Fed, prolonged lower Treasury yields, and an increasing deficit may serve as headwind for U.S. dollar against EM currencies.
However, a few idiosyncratic country specific risks and unstable credit risk exposure still hovers around this asset class. Argentina, which has been in a currency crisis since 2018, is struggling to restructure its debt after defaulting in May while Venezuela is struggling with an economic turmoil. Whereas the most recent strong rally reflects broader risk-on investor sentiment, it also highlights that economic fallout from the pandemic is highly unlikely to reach the depression-like severity that some market participants had initially feared. With the continued wave of asset flows into passive vehicles, PMC Research believes this asset class is primed for active managers to continue to shine.
Same Big Tech, Same Big Index Weight
Beau Noeske, CFA
Michael Manning, CFA
You have likely heard about how mega-cap technology names have dominated indices and therefore their performance for some time now. Well, despite a correction in Q1 and a subsequent rebound in Q2, that trend continues and is more pronounced than ever. In fact, the Russell 1000 Growth Index reconstituted its positions in the index at the end of Q2, and the concentration within a few stocks might shock you. At quarter end, Microsoft, Apple, Amazon, Facebook, and Alphabet (Google) with both its Class A and C shares represented about 10%, 10%, 8%, 4%, and 5%, respectively, of the index. In total, those five names currently represent about 37% of the benchmark. It is clear that Russell 1000 Growth Index tracking funds are concentrated, and therefore, investors utilizing index funds expecting diversification should be aware that their risk profile is also increasing as these bets in a small amount of stocks continue to grow.
Likewise, keeping up with mega-cap technology exposure in the indices has been a common point of discussion across investment managers covered by Envestnet | PMC research. One core equity manager, which has historically been underweight to these stocks noted, “There’s been a fundamental shift away from capital-intensive industries to more digital commerce. We need to accept and adapt to this reality rather than blindly relying on historical patterns.” Another factor is the current interest rate environment. Several managers pointed-out that near-zero rates lessens the long-term discounting effect and supports elevated valuations of long-duration plays like technology companies. While the Fed has signaled that interest rates are likely to remain low for the foreseeable future, should rates rise longer-term, it could have a negative impact on tech-stock valuations. Additionally, while most portfolio managers agreed that drawing parallels to the tech bubble of the late 90s is an apples-to-oranges comparison, triggers for a potential sell-off in tech could include a rotation into cyclicals with the development of a COVID-19 treatment or vaccine, or unexpected bad news hampering lofty expectations.
For example, when Microsoft announced its Q2 earnings which topped expectations but signaled weakness in its cloud growth, its share price dropped more than 4%. That forecast led to significant same-day declines in Apple, Tesla, and Amazon. While a single trading day is a small sample size, it perhaps provides a glimpse into the risks of such narrow market leadership. And with an increasingly volatile market, investors ought to be aware that these few stocks will have a material (and likely growing) impact on the market’s results and therefore its success, or lack thereof, moving forward.
The US Dollar and Wile E. Coyote
Dan Homan, CFA
My favorite cartoon growing up was Wile E. Coyote and the Road Runner. Coyote repeatedly attempts to catch the Road Runner using absurd methods, usually running off a cliff and continuing to run until he realizes there is no ground underneath him, only to suddenly plummet hundreds of feet to the earth, landing with a thud. The US dollar (USD) is currently having a bit of a Wile E. Coyote moment. After years of appreciation versus a variety of currencies, market participants in July seemed to recognize there is no longer ground beneath the USD, sending it dropping. In fact, the USD fell by over 4% in July, more than in any month in over a decade. The USD now sits at two-year lows versus a basket of currencies, having a variety of effects on the economy and investments.
There are several reasons behind the USD freefall. While the US has run fiscal deficits for many years, the gap in 2020 will be staggering, projected to be $3.7 trillion. That figure does not include any additional COVID relief bill passed by Congress, which seems imminent. The Federal Reserve has also stepped up to support the economy. Along with various other actions, its balance sheet has ballooned from around $4 trillion to start the year to around $7 trillion currently. It should be noted that this is not money backed by Treasuries, it was simply created by the Fed. Economic woes tied to the unmanaged Coronavirus outbreak, in addition to the ballooning deficit and a Fed money-printing spree, has plagued confidence in the greenback.
The effects of a dropping USD are varied and not all bad. It does create a drag on consumers, who bear the brunt of a weakening dollar by paying more for imported goods. However, a weakening dollar supports US exporters whose goods get cheaper to foreigners as the dollar falls. Also, US investors with international equity investments also benefit from a falling USD. For example, during July the MSCI ACWI ex-US Index returned only 1.4% relative to their local currencies. US based investor’s return for the month was 4.5% due to USD weakness.
Whether currency trends continue to persist into the future is anyone’s guess. However, the confluence of factors weighing on the USD do not seem to be temporary in nature. I have spoken to several emerging markets equities managers who are bearish on the USD over the long term. This scenario would create a backdrop where non-US and emerging markets, equities have a consistent tailwind behind them. Would the tailwind be strong enough for international markets to challenge the US equity market’s dominance over the last decade? This is probably a stretch given the strength of the IT sector in the US, which has benefitted from the pandemic so far. Nevertheless, the USD shifting from a persistent headwind to a tailwind would certainly be supportive of non-US equity returns.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this brochure is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. Past performance is not indicative of future results. This material is not meant as a recommendation or endorsement of any specific security or strategy. Information has been obtained from sources believed to be reliable, however, Envestnet | PMC cannot guarantee the accuracy of the information provided. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. An individual’s situation may vary; therefore, the information provided above should be relied upon only when coordinated with individual professional advice. Reliance upon any information is at the individual’s sole discretion. Diversification does not guarantee profit or protect against loss in declining markets. FOR INVESTMENT PROFESSIONAL USE ONLY © 2020 Envestnet. All rights reserved.