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Recently, market volatility has surged as economic uncertainty grips financial markets. Growth expectations have collapsed, stock market volatility is spiking, and credit spreads are widening. This environment has placed renewed focus on how different stocks respond to macroeconomic pressures — and, crucially, why quality matters more than ever.

Traditionally, market downturns and economic stress trigger debates over whether value stocks or growth stocks will fare better. However, an underappreciated factor in this discussion is quality. High-quality stocks — characterized by low leverage, profitable assets, and consistent results — have historically outperformed their lower-quality counterparts in periods of macroeconomic stress.

For years, research has highlighted the defensive characteristics of quality stocks. Academics the world over have extensively studied the relationship between stock performance, risk, and various factors. However, discussions about quality investing often oversimplify the issue. What they fail to fully appreciate is why quality has outperformed and, more importantly, how quickly market conditions can flip, making it absolutely critical to position in advance.

The Challenge of Non-Linearity

Conventional wisdom suggests that defensive equity strategies behave in a predictable, linear fashion — that quality stocks gain an advantage at a steady pace as risk rises. This assumption is flawed. In reality, the relationship between macroeconomic stress and quality stock outperformance is highly non-linear.

This non-linearity is evident in our first chart. Historically, once the VIX (market volatility index) exceeds 20, high-quality stocks, as identified using the WCA High-Quality Index, began to meaningfully outperform low-quality stocks, and the gap widened exponentially. This can happen very quickly. While many rightly assume that higher-quality stocks tend to be more defensive in downturns, most fail to grasp the speed and magnitude of this rapidly occurring, non-linear effect. Traditional risk models may well treat volatility and stock behavior as linear, but our research shows that once uncertainty crossed a certain threshold, market reactions became highly amplified. 

Blink and you can easily miss the change.

Chart 1: The Exponential Impact of Rising Fear on Quality vs. Low-Quality Stock

Past performance does not indicate future results

This non-linear relationship between volatility and quality performance raises an important question: If quality outperformance accelerates as market stress rises, shouldn’t you proactively allocate toward quality before volatility spikes rather than reacting after the fact?

Building on previous work on factor sensitivity, we now examine how different quality grades respond to macroeconomic changes — not just stock market volatility but also shifts in other outside factors like credit spreads and currency movements.

Evolving Conditions

The past three weeks have introduced renewed nervousness to markets. Concerns over tariffs and persistent inflation are dampening economic optimism. For example, GDP growth forecasts for the current quarter are weakening due to escalating trade fears. Simultaneously, equity market volatility has risen, and corporate credit spreads have widened (Chart 2). All of this signals emerging recession concerns, heightened uncertainty, and potential default risk for weaker firms. Time will tell how this all resolves.

Chart 2: The Macro Stress Factors in Action

Each of these macroeconomic signals point to a familiar and common theme: high-quality stocks are generally better positioned to withstand these external pressures than their lower-quality counterparts.

For the record, since the stock market peaked in the third week of February, the S&P 500 is down 8.5%, while the aggregate bond market is up 1.7%, reflecting concerns about slowing growth. However, the stocks with the lowest quality and highest valuations have suffered the most. The WCA “Low” Quality Index is down 10.3%, and the Bloomberg 1,000 Growth Stock Index is down 11.2%. By contrast, the WCA “High” Quality Index is down just 1.9%, significantly outperforming other equity categories. This reinforces our findings: lower-quality stocks tend to experience disproportionate losses as uncertainty rises, while the representation of high-quality assets were shown to have provided relative stability.

Quality Tempers Volatility When Macro Factors Unexpectedly Change

As we move down the quality spectrum from “A” (higher quality) to “F” (lower quality), the stocks in each category become increasingly sensitive to outside, macroeconomic factors — reacting more violently to widening credit spreads or currency fluctuations, for example. A more nuanced point here should also be made. Not only do lower-quality stocks experience greater average sensitivity to external shocks, but there is also a far greater uncertainty regarding how any individual company will perform in response to these factors. The range of possible outcomes in the face of an external shock is far greater the further down the quality scale we go (note the rising standard deviation for each group indicated in grey on the chart below). Lower quality translates into more sensitivity and greater uncertainty of outcomes.

While it is widely understood that quality tends to offer defensive characteristics, the exact way that this plays out is less well appreciated. Our research clarifies that high-quality stocks may offer some relative stability when volatility spikes and markets adjust rapidly. Additionally, we see how different macroeconomic factors can disproportionately impact lower-quality firms and create unwanted risk in the process.

Chart 3: Sensitivity to Economic Factors By WCA Quality Grade

What if Markets Are Wrong?

Yes, the market has recently taken a step back. But if anything, the past few months and years have shown just how short-sighted and reactive the market can be.

Despite the recent correction, the S&P 500 remains up 11.2% over the past 52 weeks. Moreover, the broader economic backdrop still includes elements of strength, including resilient labor markets and steady consumer spending. If these factors stabilize sentiment, lower-quality and growth stocks could rebound as market participants re-engage with riskier assets. With so much changing daily, predicting the next move remains challenging.

In such an environment, maintaining a focus on enduring quality makes tremendous sense. Whether volatility rises or subsides, high-quality investments may provide a stabilizing force, offering both resilience and potential for long-term outperformance. A key factor is to be positioned ahead of time.

Contacts:

Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Head of Portfolio Risk
Suzanne Ashley, Relationship Manager
Eric Needham, Sales Director
Jeff Battipaglia, Sales and Marketing
(973) 549-4168

www.washingtoncrossingadvisors.com

Disclosures:

WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

The S&P 500 Growth measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum.

The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.

The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors, LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF). Registration with the SEC implies no level of sophistication in investment management.