To Reflate or Stagnate
Overview
- Even as economic data deteriorated towards the end of 2019 and earnings were lackluster, investors pushed up the valuations of stocks to all-time highs seeing through the often difficult macro headlines.
- When it came to flows, U.S. ETFs dominated in 2019 with investors favoring cyclicals over defensives throughout the year.
- While headline risks remain high, investors have a backdrop of accommodative monetary policy, which should support risky assets even if volatility increases.
2019 in Review
2019 witnessed a disconnect between leading economic indicators and financial markets that saw manufacturing data across the globe contract, the U.S. yield curve invert, and ongoing reports of relatively modest corporate earnings, but stocks continued to make new all-time highs. In fact, 2019 brought a rally in risky asset classes across the board that, in many ways, stemmed from events that were avoided, as the worst fears around the U.S.-China trade relations and a hard Brexit did not come to fruition.
Most importantly for investors is that, in contrast to this time last year, financial conditions are extremely easy, and we believe that the Fed will be less influenced by politics in an election year than some might assume. The same can be said for major central banks around the globe as most, including China, have recently embraced more accommodative stances with a bias toward additional easing.
FIGURE 1: EQUITIES HAVE RISEN WITH THE MONEY SUPPLY
Source: Bloomberg Finance, L.P., as of December 31, 2019. Global equities are represented by the MSCI ACWI Index and Global Money Supply is proxy for the global money supply across Australia, Brazil, China, the Eurozone, Japan, Mexico, Russia, South Korea, Switzerland, Taiwan, and United States. Past performance is not indicative of future results. One cannot invest directly in an index.
U.S. MARKETS LED THE WAY LAST YEAR
Geographically, U.S. markets were the overwhelming winner in 2019, beating international markets by 9.23%. The Russell 1000® Index had the second best return in the decade and seventh best since its inception. Last year’s gains were broad-based with all sectors in the green. With the Russell 1000® Growth Index returning 36.39%, growth stocks beat value last year by 9.85%. Even more impressive was cyclical sectors outperforming defensive sectors by nearly 15%. This contrasts to the narrative that last year was a risk-off rally as large caps beat small caps again by a healthy margin as investors favored higher quality companies in the face of economic uncertainty. Investors went up in quality overseas as well with emerging markets (EM) underperforming their developed markets (DM) counterparts by 4.80% in 2019.
We did witness a reversal of some trends recently into year-end with international equities outperforming their U.S. peers by 1.46% and EM rallying 7.32% to beat DM by close to 4% in December. Some are calling for this reversal to continue into 2020, but we have less confidence that some of these will persist meaningfully as the trends of 2019 roll into 2020. With that being said, however, we are keeping an eye on emerging markets equities, specifically, as they look interesting from both a positioning and relative valuation perspective.
FIGURE 2: CYCLICALS RELATIVE TO DEFENSIVES SAW THE GREATEST PERFORMANCE SPREAD
Source: Bloomberg Finance, L.P., as of December 31, 2019. The data is representative of the 1-month and 12-month returns of the indexes found in the Definitions list below. Past performance is not indicative of future returns. One cannot invest directly in an index.
Investors Stayed Home in 2019
Like performance, ETF flows heavily favored the U.S. relative to other regions, and U.S. large caps were in favor relative to small caps for nearly the entire year. Investors also favored developed market ETFs compared to emerging markets products, and cyclical sectors compared to defensive sectors, but the magnitude of flow leadership were really in the U.S. relative to international and U.S. Large Cap relative to Small Caps spaces. Thanks to $6.39 billion of inflows compared to $1.34 billion in the fourth quarter, investors favored ETFs focused on value stocks even after they continued to suffer relative to growth. Notably in December, defensive sector ETFs took $1.43 billion, while cyclical sector ETFs saw $3.18 billion of outflows.
FIGURE 3: U.S. Equities Dominated ETF Flows
Source: Bloomberg Finance, L.P., as of December 31, 2019. Data displays the difference in net flows of ETFs tracking the five pairs of equity segments relative to one another. Each equity segment is comprised of a group of ETFs that track indexes that are representative of those broad exposures, covering both the broad domestic and broad international equity market segments that are representative of the indexes found in the Definitions list below.
To Reflate, or to Stagnate? That is the Question.
It’s not quite Shakespeare, but a key question for investors in the early days of 2020 should be whether the calls for reflation due to improving economic fundamentals come to fruition, or whether we enter a period of stagflation that sees the current low of economic growth coinciding with rising prices. Investors should expect earnings and economic data to reflect, and match, the multiple expansion we saw in risk assets in 2019. Recent data, however, points to global growth not showing signs of bottoming just yet.
While a portion of 2019’s headlines remain, and new ones have emerged in the first days of the year, investors should not forget about the supportive backdrop of loose monetary policy. In a continued late cycle economic environment, but with extremely supportive monetary policy, we favor cyclical sectors, but not across the board. We also advocate that investors may want to begin thinking about some defensive positioning as volatility should increase.
Current Positioning
Figure 4 highlights the current positioning of our quantitatively-based Relative Weight Model. These views are recalibrated monthly based on composite measures of momentum and valuation.
FIGURE 4: Relative Weight Positioning
| Momentum Composite | Valuation Composite | Overall | |
| U.S. Large Cap / Small Cap | Large Cap | Small Cap | Large Cap |
| U.S. Growth / Value | Growth | Value | Growth |
| Cyclical Sectors / Defensive Sectors | Cyclical Sectors | Neutral | Cyclical Sectors |
| U.S. / International | U.S. | International | U.S. |
| Emerging Markets / Developed Markets | Neutral | Neutral | Emerging Markets |
Source: Direxion, as of December 31, 2019.
Definitions
- Russell 1000: The Russell 1000® Index consists of the largest 1,000 companies in the Russell 3000 Index, which is made up of 3,000 of the largest U.S. companies.
- Russell 2000: The Russell 2000® Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
- Russell 1000 Growth: The Russell 1000® Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
- Russell 1000 Value: The Russell 1000® Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values.
- MSCI USA Cyclical Sectors: The MSCI USA Cyclical Sectors Index is based on MSCI USA Index, its parent index and captures large and mid-cap segments of the US market. The index is designed to reflect the performance of the opportunity set of global cyclical companies across various GICS® sectors. All constituent securities from Consumer Discretionary, Financials, Industrials, Information Technology and Materials are included in the Index.
- MSCI USA Defensive Sectors: The MSCI USA Defensive Sectors Index is based on MSCI USA Index, its parent index and captures large and mid-cap segments of the US market. The index is designed to reflect the performance of the opportunity set of global defensive companies across various GICS® sectors. All constituent securities from Consumer Staples, Energy, Healthcare, Telecommunication Services and Utilities are included in the Index.
- FTSE All-World ex US: The FTSE All-World Excluding United States Index is a free float market capitalization weighted index. FTSE All-World Indices include constituents of the Large and Mid-capitalization universe for Developed and Emerging Market segments.
- MSCI EAFE IMI: The MSCI EAFE Investable Market Index (IMI), is an equity index which captures large, mid and small cap representation across Developed Markets countries around the world, excluding the US and Canada.
- MSCI Emerging Markets IMI: The MSCI Emerging Markets Investable Market Index (IMI) captures large, mid and small cap representation across 24 Emerging Markets (EM) countries.
- MSCI ACWI Index: The MSCI ACWI Index is designed to represent performance of the full opportunity set of large- and mid-cap stocks across developed and emerging markets.
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