Many Happy Returns, Now What?
August 2019
The S&P 500 stood out on the world stage during the month, adding another 1.3 percent onto June’s impressive 6.9 percent price return, on its way to an 18.9 percent year-to-date price return through July. Small-cap stocks, exhibited by the Russell 2000, rose 16.7 percent in price year-to-date through July after rising one half of one percent during the month. Non-U.S. stocks were a drag on performance in July, as developed-international and emerging market stocks fell 1.3 and 1.7 percent, respectively, during the month.
Due to uncertainty and dysfunction within the Eurozone tied to Brexit, we remain underweight developed international stocks relative to our long-term target, and, aside from appealing valuations, we see little incentive to increase exposure. Our position in emerging market stocks remains above our strategic target, although our conviction level has waned as U.S./China trade negotiations have grown increasingly combative. There will be beneficiaries from shifts in the global supply chain away from a dependency on China, but this will take years to play out. An economic slowdown in China, unrest in Hong Kong, and a devalued China yuan has generated capital flight out of emerging market indices, and these risks appear here to stay for a bit longer. As is often the case, uncertainty breeds opportunity, and opportunity in emerging markets is what we continue to see, but a bumpy ride should be expected.
Due to their economic sensitivity and higher debt levels, small-cap stocks should benefit from the recent Fed funds rate cut, and any subsequent cuts. Interest expense on debt, a significant cash flow drain for many smaller companies, should fall over time as existing debt rolls off and new debt comes on at a lower interest rate, all else equal. Along with lowering interest expense on debt, a rate cut could also prolong the economic expansion, providing fledgling companies a longer runway to get off of the ground. Small-caps aren’t usually outperformers late in the economic cycle, and this time appears to be no different. The implementation of additional tariffs on Chinese imports would drive costs higher, offsetting the benefit this group would receive from lower interest rates.
With long-term interest rates hovering near 3-year lows, perhaps moving lower still, investors remain focused on income generation. The estimated next twelve months S&P 500 dividend yield of 2.0 percent is now 26 basis points above the yield on 10-year U.S. Treasury notes, making the bird in the hand, i.e. dividend yield, increasingly in demand, boosting investor appetite for stocks that look like bonds. S&P 500 real estate, consumer staples, and utilities, primary beneficiaries of the yield grab, are trading 10, 6, and 25 percent above their 10-year average trailing price to earnings ratios. These sectors aren’t cheap, but all carry yields above that of the S&P 500 overall, and that’s what matters most right now.
The CBOE Volatility Index, or VIX, a measure of investor “fear,” averaged just over 13 during July, implying heightened investor complacency and little desire to hedge against a decline in stock prices. VIX spiked from 12 to 24 to begin August as President Trump announced 10 percent tariffs on an additional $300 billion of imports from China effective September 1. China has since countered with an announcement that it would halt purchases of U.S. agricultural products. Stocks are entering into what has historically been a seasonally weak period from August through September, which, when combined with U.S./China trade escalation provides us with the recipe for a volatile month. With the FOMC meeting and most of earnings season behind us, investors will shift their focus to trade chatter, leaving share buybacks and likely little else to support equity prices as we enter into the late summer months.
Source: Bloomberg, Factset
