By Richard Bernstein, Richard Bernstein Advisors
China’s stock market was one of the worst performers during 2018. The combination of a trade war and slowing global growth was not a good one for such an export dependent economy. However, the weakness in external demand for Chinese goods led the government to stimulate the domestic economy with significant monetary and fiscal programs. In fact, China is the only major economy that is attempting to incrementally stimulate their economy.
One of the reasons we were so bullish on the US economy earlier in the decade was our belief that monetary and fiscal stimulus would work. Many pundits suggested the US economy would have an “L” shaped recovery, meaning that the economy would basically never recover from the “Great Recession”, and that the business cycle was effectively dead. The US economy did, of course, recover and there was a significant bull market.
There are similarly negative statements made today regarding the future of the Chinese economy, and how their monetary and fiscal efforts will prove impotent.
Chart 1 shows that there may be hope for the Chinese economy because of those stimulative measures. The chart compares the OECD Leading Economic Indicator for China versus that of the US, and the two indicators have been moving in opposite directions. Whereas the US indicator (green line) is increasingly suggesting an economic slowdown, the Chinese indicator (blue line) is beginning to improve. The China Leading Indicator’s recent improvement is quite unique. Chart 2 highlights that China is one of only two major economies with improving leading economic indicators (Australia is the other).
Admittedly, Chinese corporate profits have yet to improve, but evidence is starting to build that they might accelerate in 2019. China is our primary overweight outside the US.
CHART 1:
China vs. US: OECD Leading Indicators
Source: Richard Bernstein Advisors LLC, OECD, Bloomberg Finance L.P.
CHART 2:
LEI Momentum
Based on 1/14/19 OECD Release
Source: Richard Bernstein Advisors LLC, OECD
Stable growth may be more important than Value vs. Growth
Consensus seems to favor value stocks over growth stocks for 2019, but that dichotomy may be the wrong way to frame the issue. Rather than value versus growth, we think a better comparison is stable growth versus cyclical growth.
Value traditionally outperformed growth when profits cycles accelerated because value stocks historically tend to be more cyclical than are growth stocks. However, growth outperformed value during 2018 as the profits cycle accelerated largely because growth stocks were more cyclical than value stocks. Chart 3 points out that growth stocks within the S&P 500® outperformed value stocks by about 900 basis points during 2018.
Chart 4 includes our forecast for S&P 500® reported earnings growth for 2019, and we expect the profits cycle to slow as the year progresses. We do not anticipate a full-blown profits recession, but we see profits growth slowing from roughly 25% in 4Q18 to roughly 5-7% in 4Q19. Historically that would argue growth might outperform.
The problem with the traditional growth and value comparison is that both market segments are currently comprised of cyclical stocks. Chart 5 shows that value universes are presently dominated by financials, whereas growth universes are dominated by technology. The earning streams of both financials and technology are highly cyclical, so the argument today regarding growth versus value is simply one of cyclicals versus cyclicals.
CHART 3:
S&P 500® Growth vs. Value 2018 Performance
Source: Richard Bernstein Advisors LLC, Bloomberg Finance L.P.
CHART 4:
S&P 500® Reported Y/Y Trailing GAAP EPS Growth from Dec. 1980 -Sep. 2018
Source: Richard Bernstein Advisors LLC, Standard & Poor’s
CHART 5:
Relative Sector Weights:
S&P 500® Value Index vs. S&P 500® Growth Index
Source: Bloomberg Finance L.P.
Stable growth is typically a critical characteristic when profits cycles decelerate. After all, cycles are determined by cyclicals, and if the profits cycle is indeed going to decelerate in 2019, then accordingly one should underweight cyclicals and overweight stable growth.
Overweighting stable growth has been considerably more important when the profits cycle decelerated than has worrying about growth or value. Chart 6 shows the performance of S&P 500® sectors when the profits cycle decelerates. Technology and Financials have historically been the
2nd and 3rd worst performing sectors when profits decelerated.
CHART 6:
Average Performance when Profits Decelerate: S&P 500® Sectors
(Sep. 1989 – Dec. 2015*)
*Last profits cycle trough
Source: Richard Bernstein Advisors LLC, Standard and Poor’s, Bloomberg Finance L.P.
Still little incentive to take duration risk
RBA avoided duration risk during 2018, and that proved to be prudent. Chart 7 shows the 2018 total return of various fixed-income indices, and shorter-duration bonds uniformly outperformed longer-duration ones.
For example, the Bloomberg Barclays 1-3 Year Treasury Index was up roughly 2% for the year, whereas 20+ year Treasuries returned-2% with substantially more volatility.
We continue to see little incentive to take duration risk within our portfolios. Chart 8 shows the term premium through time for the 10-year T-note. The term premium simply suggests whether it is better to buy one 10-year note or better to roll over 10 one-year notes. The recent term premium has been historically negative. A negative term premium suggests that investors are underpricing duration risk and that shorter- term notes will probably outperform longer-dated ones.
A negative term premium is a relatively rare occurrence (limited primarily to the current period and the early-1960s), but shorter-term notes have outperformed longer-term ones during most 12-month periods in which the term premium was negative. More importantly, RBA’s research shows that there is a strong correlation between the term premium and the probability and magnitude of longer-term notes out/ underperforming over subsequent 12-month periods.
CHART 7:
Fixed Income Indices 2018 Total Returns
Source: Bloomberg Finance L.P.
CHART 8:
10-Year Treasury Term Premium (Jun. 16, 1961 – Jan. 14, 2019)
Source: Bloomberg Finance L.P.
2019’s potential risk
Investors and companies are typically the most bullish at a market’s peak. Instead of reducing risk as market peak nears, investors and companies add cyclicality and ignore the business cycle because they believe “this time is different”. The resulting buildup of operating and financial leverage exacerbates cyclicality, and the businesses and the stock market become most sensitive to the economy right at the peak of a cycle.
The fourth quarter’s emotional “run” on the market might be setting up such late-stage over-optimism. Although there is limited evidence that the corporate sector is accentuating cyclicality, some stock market investors are claiming that a new market cycle has begun despite that the yield curve has continued to flatten since market volatility rose (see Chart 9) and slowing earnings growth rate forecasts. Investors should be wary of a strong market rally during 2019 if that rally is coupled with waning profitability and an inverted yield curve. Increasing investor optimism amid deteriorating profits and liquidity has rarely, if ever, ended well.
CHART 9:
Slope of the US Treasuries Yield Curve: Sep. 30, 2018 vs. Jan. 15, 2019
Source: Bloomberg Finance L.P.
Initial 2019 positioning
Although RBA’s various portfolios differ by risk characteristics and asset categories, the following general themes are embedded in our portfolios as we begin 2019:
We remain overweight equities, but not by nearly as much as we had been for the past several years. This reflects our view that profits growth will slow, but no profits recession is yet on the horizon.
We prefer to accentuate stable growth rather than either traditional growth or value. The growth and value universes are both presently dominated by cyclical industries that tend to underperform when profits decelerate.
Chinese stocks might present opportunities in 2019. Although our profit indicators have yet to turn (which would remove our uncertainty), China is the only major economy actively stimulating via monetary and fiscal policy. In addition, China is one of only two major economies in which leading indicators are accelerating. Profits remain a sizeable question mark.
The term premium is historically negative, and our fixed-income holdings are primarily short-maturity Treasuries. A negative term premium suggests that investors are underpricing the risks of longer-duration bonds. A decelerating profits cycle suggests quality over credit.
To learn more about RBA’s disciplined approach to macro investing, please contact your local RBA representative. www.rbadvisors.com/images/pdfs/Portfolio_Specialist_Map.pdf