A new environment
Market volatility has upended the recent trend favoring growth and momentum stocks. Further, the historical lack of correlation between stocks and bonds – which heavily influences how many investors structure portfolios – has sputtered in the current environment. How investors respond to breaking news or policy action has frequently caused the two assets to become positively correlated.
Going forward, Vaughan Nelson expects the correlation between stocks and bonds will continue to be spurious. At times, this could mean that bonds provide less of a cushion on the downside. Investors may want to prepare their portfolios for changed market dynamics in the year ahead.
Stocks and bonds – still correlated?
The idea that stocks and bonds are inversely correlated informs how many investors structure their portfolios – including how investment strategies are selected and implemented. This investing tenet has been with us for several decades – the product of a declining interest rate environment, coupled with a period of secular balance sheet leveraging and quantitative easing on the part of the US Federal Reserve. Not surprisingly, this was a perfect environment for stocks and bonds to be inversely correlated.
Now, we’re moving into a period where the exact opposite could be true. It gets back to volatility driving de-risking – or investors moving into less risky assets – and the effect of market volatility on stock-heavy portfolios. In short, increased volatility often leads to more volatility, which can create an environment where the performance of stocks and bonds is far less predictable.
Tilting toward value stocks
Momentum and growth stocks have been the primary beneficiaries of the low-rate environment and global quantitative easing1. As a result, value investors – managers focused on fundamentals and valuations – have struggled to keep pace with their growth counterparts. As the US Federal Reserve steps away from an emphasis on liquidity, we believe the market will again look to companies with fundamentally sound characteristics.
The shift towards value may be a bit nuanced. The performance spread between growth and value was as high as 1300 basis points at its 2018 peak. As the Fed reprices short rates higher and investors earn about 3 percent on a two-year US Treasury, longer-duration assets such as 30-year Treasury bonds or growth stocks are worth less in comparison because future cash flows are worth less.
Identifying value stocks is also challenging in this environment. It is easy to point to stocks with low price-to-earnings ratios2 and to superficially find them attractive. However, it is actually very difficult to find a stock that is trading at a low multiple relative to overall value. In other words, the truly cheap stock with attractive fundamentals and valuations often remains elusive.
Meeting the challenges ahead
Vaughan Nelson believes market volatility will continue in 2019 and correlations between asset classes will continue to shift as the liquidity that has been built up in global markets continues to seep out. As investors, we believe active managers stand to benefit. This is because active managers can react directly to pricing pressures related to fundamentals and valuation on stock prices.
With keen insight into prevailing macro trends, policy shifts, and business fundamentals, skilled stock pickers have an opportunity to benefit as liquidity ebbs. Concentrated flexible portfolios that buy securities based on fundamentals, calculated merit, and future growth expectations could be well positioned for these near-term shifts in the investment landscape.
2 The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS).
All investing involves risk, including the risk of loss.
Natixis Distribution, L.P. is a limited purpose broker-dealer and the distributor of various registered investment companies for which advisory services are provided by affiliates of Natixis Investment Managers.
The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary.