Growth Stocks Win Again | Financial Times

Good morning. Global Tiger is trying to sell a large chunk of its portfolio of private companies in the secondary market. It needs cash to pay its investors. We’ll see more stories like this in the months to come; the economic cycle applies also to private assets. Email us: robert.armstrong@ft.com and ethen.wu@ft.com.

Growth stocks in an economic downturn

Friday we he wrote that various economic reports and indicators are now, for the first time in some time, “singing from the same anthem”. We are in for a sharp and pronounced slowdown, offset only by seemingly irrepressible consumption (which may soon be stifled by a weaker labor market and dwindling savings).

As the economic backdrop becomes clearer, how are equity investors responding? Well, as a first approximation, they are responding by buying growth stocks:

As has been the case throughout the cycle, rates are part of the stock’s growth story. Growth began to seriously outperform in the first few weeks of March after troubles with regional banks began and as the 10-year Treasury yield fell from 4 percent to 3.5 percent, where it has remained since.

This is not, however, a pure rate story. It makes a lot of sense to avoid even value stocks in a downturn. Low-rated stocks tend to have more cyclical business models, more debt, and more vulnerable business models than higher-rated growth stocks. They they tend to do well in economic recoveries and badly in slowdowns and recessions.

So maybe what we’re seeing is more of a move away from value than a move towards growth. Either way, the result is a very lopsided market, at least in terms of S&P 500 sector performance. Nearly all of the positive returns come from the growth/communications technology, information technology, and consumer discretionary sectors (remember that consumer discretionary is heavily weighted on Amazon and Tesla).

As Robin Wigglesworth pointed out Alphaville last week, AI-related tech stocks are doing much of the heavy lifting. He cites research from SocGen that found that, were it not for AI trading, the S&P 500 would be down 2% this year, rather than 8%.

High-quality stocks are also expected to outperform in a downturn (“Quality” generally refers to companies with high barriers to entry and, consequently, a high return on equity; often also low leverage and low volatility of profits are factors). But because the growth and stock quality screens collect many of the same stocks, it’s sometimes hard to make sense of what’s going on. I divided the S&P into quintiles based on year-to-date stock performance and then looked at various growth and profitability metrics within the quintiles. While the top two quintiles had higher equity returns than the bottom three, the clearest signal was the outperformance of stocks with high valuations and recent rapid growth:

Interestingly, as Todd Sohn of Strategas pointed out last week, the sector generally considered the most defensive, consumer staples, has performed only modestly recently. In a downturn, stable profits from core companies should be attractive. Sohn offers one possible explanation. There are only three basic S&P 500 stocks offering dividend yields above 5.22% available on a three-month Treasury (these are Altria, Walgreens Boots and Phillip Morris). The appeal of defensive stocks diminishes when you have a short-term risk-free asset that offers a positive real return.

In the entire S&P, I counted 38 stocks with dividend yields higher than the yield on 3-month Treasuries. Eleven of them are regional banks, eight are energy stocks, four are real estate investment trusts. Basically all 38 are highly leveraged or highly cyclical. None of them seem, at first blush, like stocks to own in a recession.

All of this begs the question: What is a defensive stock today, when the role of reliable real yield is played by Treasuries or other cash products? Could this sound like a growth stock?

Playing the debt ceiling is difficult

The best debt ceiling bet is the boring one. While both sides have reason to take some calculated risk, neither side wants a default. So a last-minute deal will likely close, as it has before. Most markets do not discount much, if any, debt ceiling risk.

Some are, though. One-year credit default swap spreads are at historic highs and one-month bills are trading at yields 40 bps above prevailing short-term rates. THE possibility of miscalculation is high enough and the catastrophic impact on the market is large enough for investors to worry about a technical default. But understanding what might happen in the markets if the debt limit is breached is very complicated. Branching decisions e unknown quantities make it actually guesswork.

We spoke to some FX specialists last week what a technical default would mean for the US dollar. Most, but not all, expected a flight to safety that would strengthen the dollar. This made sense to us. Yet a recent JPMorgan survey of 123 of its institutional clients found that more than 70% expect a technical default to weaken the dollar against the yen, Swiss franc and euro.

What about Treasuries? JPMorgan’s fixed income strategists think short- and long-term yields will decline as Date X approaches (when the government runs out of cash), noting that on average 10-year yields have declined by around 30bp around near missed debt limits in 2011 and 2013. Our regular correspondent Ed Al-Hussainy of Columbia Threadneedle adds that a bet on lower yields could work well if the authorities intervene to keep markets going, probably with some sort of mini program of quantitative easing. But he warns: “The initial level of rate vol is too high for a strong directional bet.”

However, if a technical default results in a downgrade of US sovereign credit, higher yields are likely to follow, argues Renaissance Macro’s Stephen Pavlick. He points out that investment funds with AAA-rated investment mandates could be forced to divest from Treasuries, structurally reducing demand. How likely is a credit downgrade? Morgan Stanley’s public policy team explains (remember S&P downgraded US debt in 2011):

Both Fitch and Moody’s recently commented that if they saw the likelihood of a default materially increase on Date X, they would likely move their AAA ratings to negative watch or outlook. In fact, Moody’s switched to negative watch in July 2011 about three weeks before Date X and Fitch did so in October 2013 two days before Date X. Although neither ended up downgrading and eventually removed the negative clock, shows that it is again a possible outcome.

After a default, the rules are clearer about what happens: initially, going beyond date X would probably see a much higher probability that the rating agencies would shift their ratings to negative watch, if they haven’t already. However, the actual rating downgrades would likely only come after an actual non-payment where the rules are clearer.

For shorter-term Treasuries, the main question is how the Treasury Department would navigate its obligations in a technical default scenario. It could resort to “prioritization,” paying off debt instruments with money intended for other programs, such as Medicare or the military. This, writes Morgan Stanley’s Efrain Tejeda, could provide some, but not total, relief to the bill market, simply because the Treasury may still run out of cash to pay the bills.

This is slippery stuff to write about, let alone trade. Leaving it out might be the best move. Judging by where the returns on the bills are, some investors are already planning to. (Ethan Wu)

A good read

Thoughts on writing by Prince Harry’s ghostwriter.