Stocks: Riding The Storm Out
July 2018
After displaying amazing resiliency through most of June, domestic equities sold-off late in the month amid ongoing trade rancor, another rate hike out of the Federal Open Market Committee (FOMC), and quarter-end portfolio rebalancing. The S&P 500 eked out a 0.48 percent return for the month, while the small-cap Russell 2000 did a bit better, posting a 0.58 percent return. Abroad, the MSCI All Country World (ACWI) ex US Index fell 1.88 percent and the MSCI Emerging Markets Index really took it on the chin, declining 4.57 percent. It’s notable that the U.S. Dollar Index (DXY) rose around half of one percent during the month, so steep declines in foreign equity markets have likely been derived predominately from capital flows into U.S. assets, specifically Treasury bonds and money markets, amid this ongoing geopolitical uncertainty.
For the first time since the 2007-2009 Financial Crisis, cash appears to be a palatable alternative for investors looking to get away from the fray. Prior to the past few months, investor preference would likely have been to move into high yield bonds or even longer-dated Treasury bonds, but with the Fed funds rate climbing higher and the spread between the yield on 2-year and 10-year U.S. Treasury bonds compressing down to a cycle-low of 33 basis points, and with inflation showing nascent signs of life, investors aren’t being properly incentivized to take on interest rate risk at the present time. The trailing 12-month yield on the S&P 500 is 1.93 percent; the current 2-year U.S. Treasury bond yield is 2.52 percent, and the 10-year U.S. Treasury yield sits at 2.85 percent. Not much of a competition between short-term bonds and stocks - if income and preserving purchasing power is your aim anyway.
Investors seeking to deploy capital into assets positively correlated to what looks and feels like a robust U.S. economic backdrop, i.e. stocks, are facing a dilemma unlike any other over the past decade. The revenue hit that multinational U.S. companies could potentially take should a protracted trade war materialize could be substantial and should not be underestimated, but it’s also difficult to handicap negotiations as an about-face could easily turn the tide in a less detrimental direction. It’s also difficult to ignore the relative attractiveness of clipping a 2.5 percent coupon from a 2-year U.S. Treasury bond while waiting for the trade dust to settle.
With the FOMC poised to pull short-term interest rates higher still over the coming quarters, expected returns on short-term Treasuries will rise, bolstering their appeal and providing greater competition for higher yielding equities. When looking to add exposure to risk assets, investors have shifted capital into domestically-focused small-cap stocks, providing desired exposure to the U.S. economy while leaving them potentially less susceptible to the international brouhaha. Small-caps will likely continue to garner investor capital over the coming months as rising short-term rates amid robust U.S. economic growth should lead to continued U.S. dollar strength, a positive backdrop, relatively speaking anyway, for domestically-focused companies.
2nd quarter earnings season begins in earnest over the coming weeks, with the consensus estimate projecting 20 percent year-over-year earnings per share (EPS) growth. With EPS expectations lofty, forward guidance and C-suite confidence, or the lack thereof, will tell the tale. A crisis of confidence from those with “Chief” in their title on earnings calls would weigh on capital expenditure plans and on expectations for share buybacks and dividend hikes. It will be worth monitoring those companies choosing to take the easy way out by lowering earnings guidance citing trade-related concerns as it’s far too early to place the blame for a future earnings shortfall squarely on the shoulders of trade. Investors will respond with their capital, penalizing those unjustifiably lowering guidance.
Source: Bloomberg
