Key Takeaways
1. The economic restart is real, but fresh macroeconomic data points to U.S. growth peaking in the middle of this year.
2. In a mid-cycle environment of “peak growth,” quality-oriented assets begin to benefit while value-oriented assets still perform due to higher-than-trend growth, causing us to recommend equity investors “barbell” value (IVLU) and quality equity style exposures (QUAL).
3. ETF flows have begun to exhibit a quality bias in Q2 and Q3 to date, with inflows picking up in ETFs tracking the quality equity style factor, U.S. government bonds, and inflation-protected fixed income (STIP).
Look Beyond The Restart
The powerful restart of economic activity after the Covid-19 shock continues to be the driver of growth in the U.S., but given markets’ forward-looking nature, it is already time to position portfolios to look beyond the restart. While investments that benefit from broad-based growth, such as cyclical and value sectors, still have room to run, we think it is time to add quality stocks to the portfolio—or those companies that will benefit once peak growth has passed.
U.S. real GDP growth came in at 6.3% in Q1 and 6.5% in Q2, disappointing expectations of 8.4% for Q2. Bloomberg consensus estimates point to a peak in Q3 of 7.1%, sliding to 5% in Q4 and 3.5% in Q1 of 2022. Moreover, a number of other economic indicators are already pointing toward a peak: the Markit U.S. Composite PMI read at 59.7 for July after soaring to 63.5, 68.7, and 63.7 in April, May and June, respectively. Similarly, U.S. core durable goods orders rose by 0.3% MoM in June, after a sharp rise from -0.5% in February to 3.3% in March, then lessening to 1.7% and 0.5% in April and May, respectively.
The bond market moved drastically last month as investors took stock of the rapidly spreading Covid-19 Delta variant and its potential to hinder the economic restart, with the U.S. 10-year Treasury yield dropping to levels not seen since February, briefly dipping below 1.15% on July 20. The equity market also showed concern, as on July 19 the S&P 500 shed -1.59%, the Nasdaq lost -1.06%, and the VIX rose to a two-month high of nearly 25.
Consider Stock 'Barbells'
While we do not expect any sharp contractions in growth despite the fears around virus variants, we may be entering a mid-cycle environment where economic growth and activity flatlines or declines from the peak, and whose beneficiaries tend to be “quality” stocks. The robust restart will continue to support cyclical, value-oriented companies, but financial markets are anticipatory, and we think that some of the early-cycle investment opportunities may have already played out, especially in the U.S.
For this reason, we favor taking a “barbell” approach to equities, pairing value with quality to access companies that may be primed to perform in a mid-cycle environment. Amidst peak growth and the ongoing risk of virus variants, a value-quality barbell strategy toward equities is likely to offer greater risk-adjusted returns and resilience to portfolios.
Indeed, flows in the equity market are already picking up, with $1.3bn of inflows to global quality ETFs in the second quarter, following $2.4bn out in Q1 (the first quarter of net outflows for the factor since 2015). While value ETFs saw steady inflows of $5bn in Q1 and $4.1 bn in Q2, they have seen modest outflows of -0.7bn Q3 to date. Quality ETFs, on the other hand, have seen inflows rising steadily by $1.3bn in Q2 and $2.0bn Q3 to date.