Value: Dead or Just Slumbering?

The Pyramid complex at Giza, Egypt.

Despite stalling in recent weeks, U.S. equities remain at or near historical highs with many indexes enjoying double digit gains. But not all segments of the market have fared so well: Many of the reflation trades that dominated late 2016 have reversed. This has been most evident at the style level.

After a stellar second half of 2016, value stocks have largely sat out this year’s rally. The S&P 500 Value Index has gained roughly 3% year-to-date, a bit of an embarrassment compared to the 15% rally in the S&P 500 Growth Index.

Why has growth done so well while value has barely merited a look by investors? A couple of factors help explain the performance gap.

Mean reversion

While growth has crushed value year-to-date, the one-year performance numbers are more balanced: 9.6% for value and 14.5% for growth. Part of growth’s outperformance year-to-date simply reflects some “catchup” after value’s strong run in the back half of 2016.

Moderating expectations for economic growth

Although the U.S. economy is firm, we’re not seeing the pickup in U.S. growth and inflation that many had expected. Most measures of inflation have decelerated and expectations for economic growth have softened. Based on a Bloomberg survey of economists, 2017 U.S. growth expectations have fallen from 2.30% in February to 2.10% today. This is important as value tends to perform better when economic expectations are rising. In contrast, when economic growth is modest, investors are more likely to put a premium on companies that can generate organic earnings growth, regardless of the economic climate. This dynamic helps explain the strong year-to-date rally in technology stocks.

What could change this dynamic? Two things to watch, the first being events in Washington, D.C. Economic estimates have slipped in part because investors and economists have put a lower probability on tax reform and/or fiscal stimulus. If Congress started to evidence real progress on tax reform, economic expectations would likely rebound along with investor’s preference for value.

If Washington cannot rescue value, eventually investor excess will. When value outperformed in late 2016, it was the exception that proved the post-crisis rule: This has been a growth-led rally. Growth has trounced value since the market bottomed in early 2009. As a result, the relative value gap between the two styles is back to levels last seen at the peak of the late 90s tech bubble.

S&P Value to Growth P/E Ratio
S&P Value to Growth P/E Ratio

Since 1995 the average ratio between S&P Value and Growth price-earnings (P/E) ratios has been 0.45, i.e. value typically trades at a 55% discount to growth. Currently the ratio is 0.30, close to two standard deviations below the long-term average. Value has not been this cheap relative to growth since early 2000.

Relative value is a poor short-term timing mechanism, but at some point investor preferences will shift. After all, this is not the first time that value has been left for dead.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Gold Shines as Washington Stumbles

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One of the more unique aspects of this year’s market is that both risky assets as well as investments that seek to hedge those risks are advancing simultaneously. Despite last week’s selloff, the S&P 500 is up 8%, the tech-heavy Nasdaq Composite 15% and the MSCI Emerging Markets Index over 22%. Yet oddly, typical “safe-haven” hedges are also doing remarkably well, such as long-dated U.S. Treasuries and gold.

Gold’s performance, up 12% year-to-date, is particularly interesting. A hard-to-define asset, gold is often thought to perform best when either inflation and/or volatility is rising. This year has been notable for both falling inflation and record low volatility, raising the question: What is powering gold’s ascent and can it continue? Two trends stand out:

1. Real rates have flattened out

Gold is most correlated with real interest rates (in other words, the interest rate after inflation), not nominal rates or inflation. While real rates rose sharply during the back half of 2016, the trend came to an abrupt halt in early 2017. U.S.10-year real rates ended July exactly where they began the year, at 0.47%. The plateauing in real yields has taken pressure off of gold, which struggled in the post-election euphoria.

2. Political uncertainty has risen

Although market volatility has remained muted, albeit less so the past week, policy uncertainty has risen post-election (see the accompanying chart). This is important. Using the past 20 years of monthly data, policy uncertainty, as measured by the U.S. Economic Policy Uncertainty Index, has had a more statistically significant relationship with gold prices than financial market volatility. In fact, even after accounting for market volatility, policy uncertainty tends to drive gold prices.

Economic Policy Uncertainty Index

To a large extent, both trends are related. Investors came into 2017 expecting a boost from Washington in the form of tax cuts and potentially infrastructure spending—resulting in the so-called “reflation” trade. Thus far neither has materialized. While economists can reasonably debate whether either is actually needed, lower odds for tax reform and stimulus have resulted in a modest drop in economic expectations. This, in turn, has caused a reversal in many reflation trades, a development that has allowed gold to rebound.

Going forward, gold’s performance may be most closely linked with what happens in D.C. Absent fiscal stimulus, the U.S. economy appears to be in a state of equilibrium: modest but stable growth. In this environment, gold should continue to be supported by historically low real rates and continued political uncertainty. Alternatively, if Congress does manage to enact a tax cut or other stimulus, we are likely to see some, albeit temporary, reassessment of growth and a corresponding backup in real rates, a scenario almost certainly negative for gold.

While I won’t pretend to have any special insight into the Greek drama that is modern day Washington, for now my bias would be to stick with gold. Most risk estimates still suggest gold has a low to negative correlation with most asset classes, suggesting a mid-single digit allocation in most portfolios. Yes, a positive surprise out of Washington would arguably hurt gold. But for now I would prefer to bet on gold’s diversifying properties rather than political stability.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Why Investors Are Ignoring Political Dysfunction—for Now

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At this stage of the bull market, investors are contending with more than a few enigmas: Do valuations even matter? Will interest rates ever rise? And how do you explain the divergence between U.S. political dysfunction and the unnatural calm in financial markets?

That last one has become particularly troubling. Most volatility measures are near all-time lows while Washington appears in complete disarray. Nonetheless, investors are likely to continue to look past political dysfunction, at least as long as financial conditions remain this easy.

Back in May, I first wrote about the relationship between policy uncertainty and market volatility. As a proxy for political uncertainty I used the popular Economic Policy Uncertainty indexes, measures based on real-time news flow. At the time I suggested that while market volatility and policy uncertainty do move in synch, the relationship is not particularly strong. Other factors, notably credit market conditions and the near-term economic outlook, tend to be more important.

Since then, U.S. economic policy uncertainty has only risen. Although the index has been higher during the past three months, overall policy uncertainty is significantly above where it was pre-election. And yet the VIX Index, a common measure of equity market volatility, is at half of its November peak (see the chart below) and bond market volatility is about a third lower. As surreal as this seems, it is not inconsistent with history.

VIX Index

History lessons

In the past, policy uncertainty has been more likely to coincide with a significant spike in volatility when monetary and financial conditions were tightening. This was the case in the summer of 1998, during the emerging markets crisis. While the federal funds target rate was stable, credit markets had been tightening financial conditions since the beginning of that year.

Another example of this dynamic occurred two years later during the disputed 2000 U.S. election. In the fall of that year, U.S. policy uncertainty spiked along with the VIX Index, which nearly doubled from the summer lows. Not only was the U.S. faced with an unprecedented hung election, but the Federal Reserve (Fed) had been tightening in the 18 months leading up to the election. At the same time, credit spreads were up over 200 basis points (in other words two percentage points) even before the election.

Today we have the opposite set of conditions. Yes, policy uncertainty has increased and the Fed has been raising rates, but broader financial conditions are easier than they were at the beginning of the year: High yield spreads are tighter, the U.S. dollar is down and the stock market is having a stellar year. As a result, composite indicators of financial stress, such as the Bank of America Merrill Lynch Global Financial Stress Indicator, suggest less stress than in January.

What could change this happy state of affairs? A few possibilities. One is that policy uncertainty morphs into systematic stress—i.e. failure to raise the debt ceiling later this year. A more likely catalyst would simply involve tighter financial conditions, potentially a result of the simultaneous withdrawal of monetary accommodation by the Fed and the European Central Bank (ECB).

But as long as money remains relatively cheap and plentiful, investors are likely to stay unperturbed by political paralysis and dysfunction. When that starts to change, political uncertainty may suddenly morph back from farce into tragedy.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

©2017 BlackRock, Inc. All rights reserved. BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.

Is High Yield Today More Resilient to Oil Volatility? Not at Any Price

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Investors, myself included, continue to marvel at the low volatility regime. Measures of equity and bond volatility remain at or near all-time lows. As I’ve discussed in previous blogs, tight spreads and benign credit conditions support a low volatility environment.

Year-to-date, high yield and other spread products continue to produce solid returns. In the case of U.S. high yield, this is a bit surprising given the drop in oil prices, down around 10% year-to-date. After all, it was only 18 months ago that a plunge in oil prices, coupled with fears over Chinese growth, sent high yield plunging and credit spreads soaring. What has changed?

US Credit Spread

As it turns out, quite a lot. There are a number of reasons why high yield markets have been more resilient to lower oil prices:

1. Global economy on solid ground

Unlike early 2016, when investors fretted over the potential of China dragging down the global economy, most recent economic indicators point to stability.

2. Better quality in energy issuers

Today, low rated companies (CCC and below) make up a smaller portion of high yield energy issuers.

3. Smaller share of the high yield market

High yield energy is now 13% of the Bloomberg Barclays High Yield Index as opposed to 17% in early 2016. That is roughly a 25% drop in its contribution to high yield spreads.

4. Improved term structures

Energy issuers are less dependent on rolling over near-term debt. And as with all high yield issuers, companies continue to benefit from still low interest rates and easy financial conditions.

5. Lower production costs

According to research from Barclays, high yield oil and gas exploration and production (E&P) companies have slashed breakevens costs by approximately 30%, to roughly $50 per barrel. This is particularly true for those E&P firms centered in the Permian Basin in West Texas, where production costs tend to be the lowest in the continental United States.

All of this suggests that high yield is not as vulnerable to lower oil prices as it was in early 2016. Work from my colleague Miguel Crivelli confirms this view. Based on his research, when West Texas Intermediate (WTI) is between $40 to $50, high yield spreads are likely to be about 45% lower than what would have been expected based on the pre-2017 relationship. Put simply, high yield energy spreads are less sensitive to changes in oil today. For every dollar increase in oil prices, high yield spread in energy only moves two-thirds as much as it would have before 2017, when oil prices were in the same range.

That said, the fact that high yield has become more resilient does not mean the sector is now agnostic to the price of oil. At some price point, a good portion of energy issuers will find themselves struggling to service their debt. A best guess: Oil at $35 per barrel could entail not only a significant widening of spreads for energy issuers but potential contagion to the rest of the asset class.

This is important. One factor that has kept markets aloft year-to-date has been well behaved credit markets. As experienced in early 2016, credit contagion could derail equities as well. The good news today is that the pain point, i.e. when high yield succumbs to lower oil, is a good deal lower than it was. This provides some cushion for both credit and equity markets.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

 

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 2017 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results.   ©2017 BlackRock, Inc. All rights reserved.

BlackRock makes no representations or warranties regarding the advisability of investing in any product or service offered by CircleBlack. BlackRock has no obligation or liability in connection with the operation, marketing, trading or sale of any product or service offered by CircleBlack.

BLACKROCK is a registered trademark of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. All other marks are the property of their respective owners.