We have been tracking the pace of the recovery through economic data to help determine if or when the decline in 2020 will be recaptured (here and here). This week, we are going to look at some market indicators to watch that could help determine if the recent recovery in economic data is likely to continue or if things could potentially stall out in the fourth quarter.
If the economic recovery is going to continue, then assets that are sensitive to economic growth should likely outperform assets that are defensive in nature.
From an equity standpoint, industries like Energy, Materials, Financials, Industrials and factors like high beta, leverage, and small caps should likely outperform.
In the latest example of rising GDP growth and improving economic activity (Q3 2016-Q3 2018), the following industries and factors outperformed.
Source: Koyfin.
Those industries and factors lagged during the subsequent slowdown in GDP growth and economic activity from Q3 2018 until the prior peak of the S&P 500 on February 19, 2020.
Source: Koyfin.
The following industries and factors have done well since the market bottom at the end of March 2020 but are lagging when including the drawdown in February. If the recovery is going to continue, these areas should maintain leadership and eventually make up the loses from earlier in the year.
Source: Koyfin.
Source: Koyfin.
On the fixed income side, areas that are more sensitive to credit risk like high yield, banks loans, convertibles, and business development corporations (BDCs) should likely outperform areas that are more duration sensitive like Treasuries and the Aggregate Index. This performance is mostly driven by credit spreads declining while interest rates increase.
During the economic expansion from 2016-2018, the more credit sensitive assets outperformed duration sensitive areas.
Source: Koyfin.
Source: Koyfin.
Source: Koyfin.
When economic activity slowed from Q3 2018 until the February peak, Treasuries outperformed and credit sensitive areas, like high yield and banks loans, lagged.
Source: Koyfin.
Source: Koyfin.
Convertibles have been doing well since the March bottom (they are the most equity sensitive) and the performance of the other areas has been relatively even. When including the February drawdown, the more credit sensitive areas are lagging Treasuries and the Aggregate Index.
Source: Koyfin.
Source: Koyfin.
Source: Koyfin.
Source: Koyfin.
Certain commodity markets are more economically sensitive than others. Industrial metals, like steel and copper, tend to perform better in economic expansions than precious metals, like gold and silver. Energy commodities, like oil, also tend to perform better in economic expansions compared to agriculture commodities.
This was the case from 2016-2018.
Source: Koyfin.
The opposite was true from 2018 to February 2020.
Source: Koyfin.
Oil and industrials metals have outperformed agriculture commodities since May, but gold and silver have also performed well.
Source: Koyfin.
The currency market can also exhibit cyclical vs. defensive characteristics. Currencies like the U.S. Dollar and the Japanese Yen tend to perform well in economic slowdowns, and currencies like the Australian Dollar and emerging market currencies tend to perform well in economic expansions.
From 2016 to 2018, the dollar index (DXY) was flat and the Yen declined by 11%.
Source: Koyfin.
From 2018 to February 2020, the DXY increased and the Yen appreciated against the dollar and other currencies.
Source: Koyfin.
Since the bottom in March, the DXY has declined and the Yen has been flat against the dollar, while the Australian dollar has appreciated against the dollar.
Source: Koyfin.
How these market signals develop over the next few months should provide insight into how investors are viewing the likelihood of the recovery continuing into 2021 or stalling out below trend. We will continue to monitor these trends and provide updates as conditions change.
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.
Senior Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC