Small caps out ahead on a muddy track

Brian Nick

The past week’s market highlights:

Quote of the week:

The problem with fiction, it has to be plausible. That's not true with non-fiction.” – Tom Wolfe
Each week, we will present our featured weekly topics in the context of the major themes listed below from the Nuveen Q2 Outlook:
  • U.S. economy: Late cycle has arrived.
  • Global economy: There’s still good news out there.
  • Policy watch: In an unusual twist, U.S. fiscal and monetary policies are diverging.
  • Fixed income: Bond markets offer few places to run, even fewer places to hide.
  • Equities: The bull market’s not over, but expect plenty more volatility.
  • Asset allocation: Valuations are no longer at extremes.

Equities: Cash may not be king. Prince, maybe.

On January 23, Ray Dalio, head of the world’s largest hedge fund, warned investors: "If you're holding cash, you're going to feel pretty stupid." At the time, the S&P 500 Index was busy notching record highs and Europe’s STOXX 600 was also rallying hard. Treasury yields, while above their January 1 levels, were comfortably below multi-year peaks.
Nowadays, investors holding cash or short-term bonds might feel good about their conservative allocation. For years after the financial crisis, the more generous income offered by equities relative to government debt bolstered the case for buying stocks. Indeed, the concept of “TINA”—as in “there is no alternative” to stocks given skinny Treasury yields—has long been considered a key driver of the current bull market, now in its tenth year. But on May 15, the yield on the 3-month bill (1.9%) equaled that of the S&P 500 for the first time since 2008. With short-term yields likely to rise further as the Federal Reserve continues to tighten, investors may find it even more rewarding to lend money to Uncle Sam.
That’s not to suggest that we recommend trimming equity holdings in favor of Treasuries. While stocks often endure day-to-day volatility during periods of rising interest rates, history shows that they generally perform well in such an environment over the longer term. Today’s higher rates reflect an ongoing economic expansion, along with the likelihood of a gradual Fed response to a strong labor market and healthy levels of inflation. This positive backdrop supports higher equity prices, in our view.
Given their domestic focus, small-cap stocks, in particular, have benefited from the improving economy. In addition, because of their generally low exposure to exports, smaller companies have been more insulated from revenues denominated in foreign currencies, a boon as the dollar has risen by nearly 6% since February 1. (A rising dollar hurts sales and profits of larger-cap multinationals by making their exports less competitive in overseas markets.) Add in rising earnings estimates and it’s not surprising that for the year to date, the small-cap Russell 2000 has outperformed the large-cap S&P 500, 6.4% to 2.2%.
In fixed-income markets, Treasury yields kept marching higher on the back of continued solid economic data releases in April. These include increases in retail sales (0.3%) and industrial output (0.7%), a measure of output at factories, mines and utilities. The yield on the 10-year note rose 9 basis points (0.09%) during the week to close at 3.06% on May 18. The 2-year security finished the week at 2.55%.
Looking ahead to the week of May 21, markets will be paying particular attention to Markit’s Services Purchasing Managers’ Index as a barometer of the economy’s momentum. (The services, or non-manufacturing, sector comprises about 80% of the U.S. economy.) An acceleration from April’s 56.5 reading could signal that stronger wage growth is in store. Also of interest will be May’s final reading of the University of Michigan sentiment index to determine how households are balancing the benefits of the tax cuts and a vibrant job market against the headwinds of rising gas prices.
Fixed income: Emerging-market debt offers opportunities despite dollar resurgence
Emerging-market debt (EMD) enjoyed a banner 2017. Supported by stabilizing commodity prices, synchronized global growth, and a falling U.S. dollar, the asset class returned a healthy 10.3%, according to the JPMorgan Emerging Markets Bond Global Diversified Index. With the 10-year Treasury yield remaining below 2.50% throughout the year, EMD enjoyed robust inflows amid the search for income.
In 2018, the environment has become far less friendly. The dollar has risen, driven by expectations of a strengthening U.S. economy and tighter Fed policy. Furthermore, capital has fled the developing world as rising U.S. Treasury yields have dented demand for EMD. These outflows, while dollar positive, have pressured currencies across the EM sphere, making dollar-denominated debt more expensive to service, roll over, and repay.
Recently, events in Argentina and Turkey have garnered headlines, highlighting some of the risks associated with EMD. 17 years after Argentina defaulted on its debts and 12 years after the country severed ties with the International Monetary Fund (IMF), Argentine President Mauricio Macri has asked the IMF for a $30 billion loan to stabilize the economy. The central bank has raised short-term rates to 40% from 24.75% to start the year, and the peso has lost nearly 24% of its value versus the U.S. dollar in 2018.
In Turkey, investors have been spooked by government intervention in monetary policy. Concerns over an overheating economy haven’t helped, either. And of course, China always looms large for EMD investors, with its rising level of debt and the possibility of a trade war with the U.S.
Risks and tailwinds aside, we are still constructive on EMD. Higher foreign currency reserves, smaller current account deficits, and a larger share of sovereign debt issued in local currencies may help make EMD more resilient in the face of potential exogenous shocks. As an asset class, EMD continues to offer an attractive yield spread over similarly rated U.S. corporate credit, with selective opportunities in both local- and hard-currency markets.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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