The past week’s market highlights:
Quote of the week:
“To expect the unexpected shows a thoroughly modern intellect.” – Oscar Wilde
As part of our new format, we are presenting our featured weekly topics in the context of the major themes listed below from the Nuveen 2018 Outlook:
- U.S. economy: Conditions are still running closer to “just right” than “too hot.”
- Global economy: Overseas economies are improving, but the time for surprises is over.
- Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
- Fixed income: Bond markets offer few places to run to, even fewer places to hide.
- Equities: Stronger corporate earnings growth should drive stock prices higher.
Equities: Small caps hold up in March Madness for equity markets
Like an unheralded 11th seed outlasting a top-ranked dynasty team in the NCAA basketball tournament, small-cap stocks beat their large-cap counterparts in what turned out to be a highly volatile March for U.S. equities. Throughout the month, the increasing drumbeat of a possible trade war hurt large caps disproportionately. Against this backdrop, the S&P 500 Index sustained a sizable loss (-2.5%) in March, while the S&P SmallCap 600 Index posted a healthy gain (+2.3%).
Although we saw significant catalysts for small-company growth heading into 2018, we didn’t anticipate that small caps would outperform large caps to such a degree, or so quickly. After all, over the past five years, the S&P SmallCap 600’s relative advantage has been much smaller, with an average annualized gain of 17.3%, versus 16.9% for the S&P 500.
March’s tariff turmoil notwithstanding, the current climate of economic growth and only gradually rising interest rates continues to provide a supportive environment for equities. Small companies in particular may be poised to do well, thanks in part to the recent tax law changes. Given their historically higher-than-average tax rates, small companies may benefit more from lower corporate rates, leading to higher profits throughout the year. The surprising tariff announcements further strengthened the case for small caps, whose greater domestic focus keeps them relatively more insulated from international risks such as rising protectionist trade policies.
While small-cap stocks have held up well and valuations remain reasonable, they are unlikely to post outsized gains if equity markets fail to turn around convincingly. Overall, we believe an ongoing strategic allocation to the asset class as part of a diversified portfolio continues to make sense, as it has the potential to contribute to improved risk-adjusted returns over time.
In the broader equity markets during the past week, the epicenter for much of the volatility was Technology stocks, which have long been among the top performers in the U.S. market. Despite some whipsawing, both the S&P 500 and the S&P SmallCap 600 posted a 2.0% gain for the week, bringing their year-to-date returns to -0.76% and 0.81%, respectively. Meanwhile, Europe outperformed the U.S. for the week, with the STOXX 600 Index increasing by 0.85% in U.S. dollars. Year to date, the -2.0% return for the STOXX 600 is slightly trailing that of the U.S. market.
Fixed income: We're not overly concerned about the flatter Treasury yield curve
It’s not just equities that have seesawed during the quarter. After expanding to nearly 80 basis points (0.80%) in early/mid February, the yield gap between 2- and 10-year Treasury notes narrowed to just 48 basis points on March 29. (2- and 10-year yields closed the quarter at 2.26% and 2.74%, respectively.) Such a convergence often spawns anxiety because a so-called “flattening” yield curve can be viewed as a harbinger of a recession or, at the very least, a sign that economic growth is slowing.
Indeed, U.S. first-quarter personal spending and retail sales have disappointed, and housing data has wavered. Overseas, the Eurozone’s recovery seems to have lost some momentum, as manufacturing and service-sector activity declined in February and March, albeit from high levels. But the fourth-quarter U.S. GDP report points to an economy that came into the year on a solid footing, and the tax cuts that took effect in January should help it remain there.
As a result, we believe the flattening yield curve most likely reflects ongoing strong demand for Treasuries rather than a sign of economic weakness. In the past week, the U.S. government successfully auctioned some $300 billion of Treasury securities, garnering more than enough market demand to absorb heavy new supply. Seeking fixed returns to cover their liabilities, pension funds and other institutional investors are rotating from equities, which have performed well over the past year or so, to longer-term U.S. government debt. Moreover, Treasuries and other safe-haven assets have benefited from the deteriorating risk appetite fueled by recent trade-war fears.
On the curve’s short end, the 2-year note, which is highly sensitive to longer-term Federal Reserve policy, has been hovering around a nine-year high. And the 3-month bill has seen its yield rise over the past few weeks on expectations for another Fed hike as soon as June.
A flattening yield curve sometimes sparks worry that it will actually invert, which occurs when short-term yields exceed long-term yields. Such a phenomenon is rare, often signaling a looming recession. We think this is unlikely amid a supportive backdrop of increased government spending and tax cuts—stimulus measures that, in our view, will “borrow” from future U.S. economic growth by boosting second- and third-quarter GDP.