As the S&P 500 Index breaks new records even as U.S. Treasury yields fall in anticipation of rate cuts, we believe it is time to be more cautious in overall stock and bond allocations. We see opportunities, however, to take advantage of underlying market dynamics. High-beta, small-cap and pro-cyclical stocks have not fully participated in the market advance, and we see pockets of attractive value and yield in global bond markets. As such, even as we move toward more neutral high-level asset-class views, we are pursuing stronger ideas for sub-asset class positioning, just beneath the surface.
One of the biggest puzzles facing investors in 2019 has been the way equity valuations have surged on a wave of apparent optimism at the same time as safe-haven government bond yields have plumbed new depths of apparent pessimism. One of these markets must be getting the outlook badly wrong, says conventional wisdom. Which is it?
We are not convinced there are pieces missing from this puzzle. We can go some way to explaining the phenomenon with simple mathematics: as bond yields fall, so do the discount rates on future earnings. All other things being equal, equity valuations will therefore rise. More pieces of the puzzle fall into place when we consider that both equities and bonds are pricing in the more dovish stance adopted by the major central banks—that has dragged down yields, but also supported stock markets as investors begin to anticipate the resulting stimulus effect. Both markets are manifestations of the looser financial conditions that form the objective of the new policy stance.
Looking Deeper
But we think the picture really becomes clear once we take a closer look at what has been happening within equity markets. For sure, most equity indices have performed well this year. It is important to note, however, that the United States has outperformed the more pro-cyclical, global trade-oriented European and emerging markets despite the apparently attractive relative valuations available there in January. Investor caution is evident in global equity allocations.
That caution has also been evident within the U.S. market. During this year’s rally, large-cap stocks have significantly outperformed the more pro-cyclical, lower-quality mid and small caps. Things look even starker when we split the market into low- and high-beta stocks: low-beta has been outpacing high-beta for years, and has opened up a near 14-percentage-point gap over the past 12 months alone. High-beta stocks are the more volatile of those stocks that are the most sensitive to the movements of the overall market—again, this pattern betrays how much caution and desire for safety underlies the new record highs being set by the S&P 500 Index.
That caution is warranted. The tensions between the United States and China on trade have been worsening for much of this year rather than easing, as many had expected. Concerns about deflation have gripped markets following recent soft Consumer Price Index (CPI) releases in both Europe and the United States, and volatile U.S. non-farm payrolls and wage data. The message from the European Central Bank (ECB) and the Federal Reserve about the importance of maintaining their inflation targets over the long term has become more urgent.
We think we may be in the trough of economic performance and sentiment, however. Investors were cheered by the apparently productive meeting between presidents Donald Trump and Xi Jinping at the G20 meeting at the end of June. The United States dropped its threat of new tariffs and adopted a softer stance on Huawei, and both sides pledged to keep talks open. On inflation, while CPI releases appear weak, we believe some of this is due to temporary effects, such as gaps in the data due to the U.S. government shutdown at the start of the year. After undershooting expectations in May, U.S. payrolls data bounced back strongly in June. And beneath the surface we see potential evidence of higher future inflation creeping into some of the more leading indicators.
We do think that the Fed will deliver 25 to 50 basis points of cuts by the end of the year, but, particularly after the June payrolls print, we also think we will see clearer evidence of higher inflation before the central bank has time to deliver all of the cuts that futures markets are currently pricing in. At that point, the prospect of a more benign, moderately rising inflation environment, as well as the stimulus of looser global financial conditions coming from the potential long-awaited weakness in the U.S. dollar, could make investors more inclined to adopt risk.
Potential Rotation
That could be tough for core government bonds and positive for risk assets. Nonetheless, for now the AAC has reserved a strong underweight view only for deeply negative-yielding markets such as German and Japanese government bonds. It retains a moderate underweight in U.S. Treasuries. In addition, this quarter it decided to downgrade its view on global equities to neutral.
The third quarter tends to be a time of scant liquidity and high volatility. We also anticipate a few more weak economic data prints before the picture turns around more decisively. And while the market can get things wrong, it is risky to bet against it when it expresses the kind of certainty we currently see in bond and rates pricing. As a result, our high-level asset class views have moved toward neutral market weights.