After going through a series of worries in the first quarter of 2018 (interest rate fears, trade war scare, technology sell-off, corporate earnings concerns), equity markets performed better in the second quarter and some calm returned to the markets. Investors seemed to turn their focus back to fundamentals, which are very strong, and feel comfortable with adding to their risk exposure.
Small Cap Outperformance
One area of the stock market that has done quite well this year is small cap stocks. Over the past several years these more volatile, but higher growing stocks, mostly mirrored the performance of larger stocks, but now there are several drivers of small cap outperformance which should persist into the second half of this year:
- Tax Reform: Small companies typically have a domestic facing footprint. Generally, they have a higher effective tax rate than large companies, so tax cuts have therefore benefited small companies more than large multinationals. Investors looking for improved profitability due to tax reform may have turned their focus to small caps.
- Trade Tensions: Small companies have less overseas exposure than large companies. The trade tensions with China and other trading partners and political uncertainties in Italy and Spain create threats to global trade and economic growth in the Eurozone. This prompts investors to reduce their foreign exposure and therefore benefits small cap stocks.
- US Economy: The US continues to see good economic momentum. Some key economic indicators – US PMI indices and retail sales – have picked up recently after a slowdown in Q1. US consumer confidence and small business optimism remain elevated. On the other hand, economic growth in Europe and emerging markets (“EM”) has faded somewhat due to political uncertainties, a strong US Dollar and rising US interest rates.
Small cap stocks have cheapened in the last two years as their price-to-earnings ratios have compressed. If the outperformance drivers persist, and we think they will, small cap stocks will show better earnings growth moving forward. Investors may look to small caps to add risk exposure over other asset classes.
Summer Doldrums Ahead?
The equity market’s historical tendencies from May to October are weak. We all have heard the old Wall Street saying, “Sell in May and Go Away,” which describes the markets’ poor seasonality for the six-month period from May to October. Many investors are away on vacation, resulting in lower trading volumes. Volatility is higher because liquidity is lower than it otherwise would have been. This weak seasonality has been even more pronounced during US mid-term election years and during FIFA World Cup years, which both occur in 2018.
Trying to catch a potential seasonal downturn in the market is never an easy task. We don’t advocate trying to time the market seasonality because getting it wrong could be costly. While we recognize ongoing geopolitical uncertainties (trade tensions with China, Europe, Mexico and Canada, tariffs on imported cars and trucks) will not go away any time soon, we believe global economic expansion, strong corporate earnings growth and reasonable valuations should continue to support equities. The underlying trends in US equity market indices are clearly up. Nothing in our technical analysis suggests that these US equity indices are at major inflection points or completing major tops. Therefore, we think the right strategy is to stay invested during the summer, and it should pay off this year.
We see several risks which could derail the US equity markets in the intermediate term.
- Emerging Markets Under Pressure: Emerging markets are under pressure lately. EM equities have declined about 10% since their all-time high in January. A strong US Dollar pushes down the value of EM currencies, making their Dollar denominated debts more expensive to service and increasing the costs of their commodity imports. Many EM countries have put their interest rate cuts on hold or even tightened to support their currencies. Higher US interest rates have also made EM less attractive to investors. While the concerns about EM contagion are understandable, most EM are better positioned now than during the “Taper Tantrum” in 2013 when the Fed reduced the amount of money it was feeding into the economy. The long-term outlook for EM remains positive. GDP growth is expected to pick up in 2018 and inflation remains relatively subdued. EM earnings growth remains solid and valuations look attractive relative to developed markets.
- Investment Grade Credit Weakness: US investment grade credit has underperformed US equities. The recent divergence between credit and equities is very similar to January’s divergence. In Europe, the selloff in credit has been even bigger than in the US. European equities have reacted in sympathy due in part to concerns about instability in Italy and Spain. The US is in a much stronger position. It is not unusual to see credit spreads widen in late cycles, this is not happening yet. Given what we think is healthy US economic growth, we feel comfortable with US equities.
- Global Trade Restrictions: The Trump Administration launched a series of import tariffs on Chinese and potentially other trading partners, in an effort to modernize decades-old trade agreements that favor foreign nations, and taking a stand against the theft of American corporate intellectual property. These tariffs have angered not only China, but also American long-time trading partners Canada, Mexico and the European Union. If trade deals cannot be worked out, it will cause global economic growth to decline.
- Federal Reserve: One concern we have had for some time is a Federal Reserve that is myopic in its focus on normalizing interest rates. The Fed is two years into its interest rate normalization process and has recently begun to shrink its massive balance sheet through the run-off of Treasury and mortgage-backed securities it acquired during the three rounds of Quantitative Easing. This “Great Unwind” is already wreaking havoc on emerging market economies, as well as adding to the volatility of all investment asset classes. The risk is the Fed raises interest rates too high and/or too quickly, potentially resulting in a shallow recession and cyclical equity bear market. We do not feel that this risk is imminent.
Despite these risks, our view has not changed. We think a recession is at least one to two years away and that the current emerging market correction does not turn into a global, cyclical bear market. The underlying trends in the equity markets are up, and we want to stay invested because of strong earnings growth and reasonable valuations.