This article was written by Nick Kalivas, a Senior Equity Product Strategist for Invesco PowerShares Capital Management LLC, a registered investment advisor that sponsors the PowerShares family of exchange-traded funds (ETFs).

The US added another 215,000 jobs in July and has tacked on an average of 235,000 jobs per month since May.1 While the jobs figures are generally in-line with analyst expectations, recently released business surveys from the Institute for Supply Management (ISM) point to significant divergence in US economic activity, with manufacturing showing weakness relative to the service sector.

ISM’s Non-Manufacturing ISM Report on Business rose 4.3 percentage points in July to a strong 60.3% – the 66th consecutive month of service-sector growth.2 This is significant, as service-providing sectors make up more than two-thirds of US output.3 As illustrated in the chart below, the spread between ISM’s manufacturing and non-manufacturing indices has widened to levels not seen since the Institute for Supply Management began publishing its non-manufacturing index in July 1997. (Typically, the higher the line, the stronger the outperformance by the service sector.)

Spread between ISM Non-Manufacturing Index / ISM Manufacturing Index

The relative weakness of manufacturing activity in the United States underscores several obstacles to global economic growth:

  1. Inventory overhang. US inventories rose to $124 billion in the second quarter – their highest level in nearly five years.4 Growth in inventory-to-sales ratios is also high, but stabilizing. We believe high inventory levels could weigh on industrial activity in the coming months, as firms clear out excess stockpiles, rather than making the investments necessary to replenish inventories. This overhang is especially acute in portions of the information technology (IT) sector, which have seen little to no increase in capital spending over the past three years.
  2. Weak commodity prices. Commodity prices have plunged as a result of the strong the US dollar and excess supply – particularly in crude oil reserves. While this is good for companies purchasing raw materials, weak commodity prices pose a challenge for economies dependent on the production of commodities.
  3. Overseas disruptions. On top of uncertainty over a possible Greek debt accord with creditors, a decline in the Chinese stock market is working its way through the global economy and having an adverse impact on cyclical stocks.

Given these trends, it’s not surprising to see that economically sensitive sectors like materials and energy have lagged over the first half of the year, while the consumer discretionary, financial, and health care sectors have flourished by comparison.

The divergent nature of the US economy is beginning to make its way into the equity markets, as evidenced by the S&P 500 Low Volatility Index, which has outperformed the S&P 500 High Beta Index measurably in recent weeks. In fact, as shown in the graphic below, the total-return spread between the two has reached the highest level since the summer of 2013.

Ratio of S&P 500 Low Volatility Index to S&P 500 High Beta Index

Ratio of S&P 500 Low Volatility Index to S&P 500 High Beta Index

Note that the spread has pierced the down trend line coming off of its June 2012 highs. Technically, a movement above the horizontal resistance line could signal a breakout for low volatility strategies, in my view. Why the outperformance? The unconstrained construction of the S&P 500 Low Volatility Index, which underlies the PowerShares S&P 500 Low Volatility Portfolio (SPLV), has allowed it to dynamically rotate out of materials and into financial and consumer staples shares, as stocks in these sectors become more attractively valued. By contrast, the S&P 500 High Beta Index—the index underlying the PowerShares S&P 500® High Beta Portfolio (SPHB) — has been weighed down by exposure to energy, industrials, and information technology shares.
The divergent returns between high beta and low volatility factors demonstrate how smart beta strategies can be meaningfully affected by both sector exposure and underlying index methodology. Generally speaking, pockets of recent weakness in the economy, including personal computers, chips, handsets, commodities and industrials, have played themselves out in a lot of high beta names. I believe that lower inventories and stable commodity prices could provide support for high beta holdings. Regardless, it may take a few more months before companies begin ramping up spending to replenish inventory.