Valuations support our view that U.S. stocks are positioned to underperform their international-developed market counterparts.
October 2019 Market Commentary1
Global equity markets rallied in October, with Japanese equities returning +4.9%, making it the leading performer out of the major global equity regions for the second month in a row. Within the U.S., small cap outperformed large cap, rising +2.6% versus +2.2%. U.S. equity volatility, as measured by the VIX index, declined -18.6% to 13.2. Abroad, emerging markets outperformed developed, rising +3.0% versus +1.7%.
The Federal Reserve (Fed) cut interest rates by twenty-five basis points for the third time this year. The Fed highlighted that the “current stance of interest-rate policy is likely to remain appropriate”; leading the market to reduce its expectations for a fourth rate cut later this year. The 2yr-10yr yield differential steepened, rising twelve basis points.
The USD fell -1.9% during the month, driven by weak economic data. The month began with the U.S. ISM manufacturing index posting a 47.8 reading, the lowest level since the financial crisis. A few days later, the U.S. ISM non-manufacturing index posted a 52.6 reading, versus an expected 55.0. Non-farm payrolls continued the disappointing data trend, coming in at 136k compared to the 145k expectation. Finally, retail sales showed a -0.3% monthly decline, undershooting the +0.3% expectation.
The British pound (GBP) rallied +5.3% in October, which was its largest monthly rise in over a decade, making it the best performing G10 currency of the month. Positive momentum on the Brexit negotiations supported the currency, as parliament agreed to a general election in December. Furthermore, the improved Brexit outlook and weak U.S. economic data led to the EUR-USD to reach its highest level in over the past few months.
The price of crude oil rose a marginal +0.2%. At the beginning of the month, an unexpected large U.S. crude oil inventory reading led to a sharp decline in oil prices. Prices were unable to fully rebound, even after an end-of-month reading showed a surprised decline in U.S. crude stockpiles.
Market Outlook for October
Our proprietary leading economic indicator improved month-over-month but remains in negative territory. The improvement came from a pickup in global trade and a rise in average hours worked.
Our outlook for U.S. stocks outperforming investment grade bonds remains in positive territory, the strength of the signal rose since last month. Valuation, as measured by comparing U.S. equities earnings yield to the ten-year treasury yield, continues to drive this view.
In U.S. fixed income, we believe that high yield will outperform investment grade bonds over the near term. Within the model, the declining equity volatility level and spread differential between high yield and investment grade supports high yield.
We believe that U.S. stocks are positioned to underperform versus their international-developed market counterparts. This view is supported by valuation, which compares the forward earnings to price ratio in the U.S. versus their international counterparts. Options market data also shows greater demand for price protection in the U.S. versus international-developed markets.
European stocks are expected to outperform European bonds in our model, though the strength of the signal has moderated. Four of the six explanatory variables in our model point to this conclusion, including European stock price momentum, valuation, European government yields and our proprietary U.S. stock versus bond signal
Asset Class Preferences are based on QS Investors proprietary quantitative factor models. These rules-based financial models use a combination of indicators that analyze asset valuations, investor sentiment, and the broad economy.
1 All data source Bloomberg, as of 10/31/19, unless otherwise noted. Global Equities represented by the MSCI ACWI Gross Total Return Local Index; Japanese equities by the MSCI Japan Index (MXJP), U.S. large cap represented by the S&P 500 Total Return Index; U.S. small cap represented by Russell 2000 Total Return Index; Emerging Market Equities represented by the MSCI EM Gross Total Return Local Index; the U.S. Dollar (USD) represented by the Bloomberg Dollar Spot Index; and the British pound (GBP) represented by the Bloomberg British Pound US Dollar Spot Index.
QS Leading Economic Indicator Index is a proprietary composite of economic data that QS Investors believes are significant in determining financial and economic conditions in the U.S. Past performance or any prediction or forecast is not indicative of future results. QS Leading Economic Indicator Index inception date is 1/2/1970.
A basis point (bps) is one one-hundredth of one percentage point (1/100% or 0.01%).
The British pound is the currency of United Kingdom.
"Brexit" is a shorthand term referring to the UK vote to exit the European Union.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.
Developed markets refers to countries that have sound, well-established economies and are therefore thought to offer safer, more stable investment opportunities than developing markets.
The earnings yield is the earnings per share for the most recent 12-month period divided by the current market price per share.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The forward P/E ratio is a stock’s (or index’s) current price divided by its estimated earnings per share (or estimated index earnings), usually one-year ahead.
The Group of Ten (G-10 or G10) refers to the group of countries that agreed to participate in the General Arrangements to Borrow (GAB), an agreement to provide the International Monetary Fund (IMF) with additional funds to increase its lending ability.
High yield bonds have below investment-grade ratings (BB, B, CCC for example) are considered low credit quality and have a higher risk of default.
The Institute of Supply Management (ISM) Purchasing Managers' Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction.
The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector. The NMI is a composite index based on the diffusion indexes for four of the indicators with equal weights: Business Activity (seasonally adjusted), New Orders (seasonally adjusted), Employment (seasonally adjusted) and Supplier Deliveries. Levels greater than 50 indicate expansion; below 50, contraction.
Investment-grade bonds are those rated Aaa, Aa, A and Baa by Moody's Investors Service and AAA, AA, A and BBB by Standard & Poor's Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
Nonfarm payroll employment is a compiled name for goods, construction and manufacturing companies in the US. It does not include farm workers, private household employees, or non-profit organization employees.
USD-EUR refers to the exchange rate between the U.S. dollar and the euro currency,
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.