Which asset class is wagering in the right direction - US equities or bonds? – By Gabriel Mansueto

The US equity markets performed strongly during the first three months of the year, as did most other international indices - some of which posted double-digit gains, and hence recovered most of the losses witnessed during the last quarter of 2018. Fixed income assets, which include both sovereign bonds and corporate bonds, recorded noteworthy price gains as well. While a positive market is always welcome, it is natural to question why both equity markets and sovereign bonds are moving in tandem, yet at a different magnitudes.

When investors’ sentiment is positive, shares or equities tend to outperform sovereign debt. In other words, more money is poured in to risky assets, while less goes in safer assets such as sovereign debt. This scenario has held ground over the first three months of the year and it is becoming increasingly evident that US equity and bond investors are pricing different outlooks for the domestic and word economy.

To explain this, I will analyse the performance of US cyclical and non-cyclical equities against the performance of US Treasuries. The latter are deemed among the safest assets an investor can hold in a portfolio. On the other hand, US cyclical and non-cyclical stocks or equities, are two broad equity groups made up of various US listed companies.

Businesses which fall in the cyclical stocks category, also known as consumer discretionary, are those whose performance moves closely with the performance of the economy. Therefore, cyclical businesses tend to sell products and services, demand for which tends to increase when the economy is healthy and expected to improve further. Conversely, during a downturn or recessionary fears, such businesses tend to do less well and their stock prices fall as revenues and profits diminish. Some industries which fall in this category are airlines, car manufacturers, restaurants and hotels.

On the flip side, non-cyclical companies or consumer staples, tend to be profitable irrespective of how healthy the economy is. Food manufacturers and utilities, such as power and gas producers, fall in this category. Regardless of a country’s economic situation, these goods are necessities which are not easily replaced, and hence demand for them will always be present. Share prices of such companies usually do not rally as much as cyclical companies do during an economic boom but tend to be more defensive during a down market.

Source: Yahoo Finance

Since the beginning of the year, US consumer discretionary or cyclical stocks, represented by the blue line, jumped by 21% while the more defensive US consumer staples or non-cyclical stocks gained just over 12%. The message here is clear. US and international investors investing in the US market have so far this year preferred cyclical over non-cyclical equities. These investors are betting on the current and future strength of the US economy. A strong economy will generate more corporate profits, higher employment, increasing wages and disposable income (if wage growth outpaces the increase in the level of inflation). All these factors will eventually result in higher domestic demand. Given the positive economic data surrounding the US economy, the performance of cyclical vis-à-vis non-cyclicals stocks comes to no surprise.

What is puzzling is the fact that during the same three months, when equity investors preferred riskier equities over more defensive equities, bond investors also increased their demand for safe US Treasuries. From January 2019, the yield on the 10-year US Treasury fluctuated between a high of 2.78% in mid-January to a low of 2.37% (hence bond prices increased) towards the end of March, while it started the year at 2.66%. It is now hovering in the 2.5% region. In addition to this, during the month of March, the US Treasury yield curve inverted, that is, the yield on short-term bonds turned higher compared to longer-dated issues. An inverted yield curve usually pre-empts a recessionary period. Even though this was short-lived, it did make headlines and investors’ angst was evident.

Predicting and timing markets’ next move is impossible. However, one can understand the forces driving sentiment in this market environment. On the one hand, we can safely say that the fear which loomed over markets last year was overdone. In addition, political risks have to some extent lost some steam. More importantly, we should also consider the current fiscal and monetary policy stance in the US. Despite the FED’s interest rate hikes last year, monetary policy is relatively loose and the FED’s forward guidance indicates that the US central bank intends to go slow on higher rates this year. That is positive for markets. In addition, the US is running a budget deficit worth about $1 trillion - no doubt the US government is stimulating the economy through loose fiscal policy.

While watching the financial news earlier this week, a fund manager stated, without going in too much detail, that despite the temporary yield curve inversion in March, this time it is different. While a recession is still possible, I do not think it will be one which will be caused as a result of ill-timed monetary and fiscal tightening. While investors should stay mindful of the recent rally in various asset classes, they should take advantage to position their portfolio in line with their risk profiles. Finding a balance, through a diversified portfolio which suits the financial needs of investors, and risk tolerance is key for investors to reach their investment objectives and have their mind at rest when sentiment moves south.

This article was prepared by Gabriel Mansueto, Head of Investment Advisors at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]


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