Despite predominantly bad news on the virus front, markets stayed in positive territory for the month of July. The data flow was decidedly mixed. A substantial decline in second quarter GDP and a meaningful fall in consumer confidence were offset by an earnings season that was beating expectations (though down year-over-year) and a surprisingly strong Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) Report.
While large cap tech remained a key driver, other narratives developed as well. Emerging market stocks were at the top of the heap, returning nearly 9%. These stocks were driven by two related factors. First, they generally benefit from expansionary monetary policy, which the world has in spades today. Emerging markets returns also benefited from a substantial decline in the value of the U.S. dollar. Measured in Euros, emerging market stocks gained just 4%, less than half of their U.S. dollar returns. That same expansionary monetary as well as expansionary fiscal policy, along with an expanding U.S. government deficit, has taken its toll on the dollar. The Euro has risen from recent lows of 1.07 on March 20th to 1.18 at the end of July while the broader DXY index, which measures the value of the U.S. dollar relative to a basket of foreign currencies, has fallen nearly 10% over the same period.
Small cap stocks have also been a historical beneficiary of expansionary monetary policy. Conventional wisdom points to small caps’ higher leverage as a source of outsized benefit from lower interest rates. As perhaps an exaggerated expression of this impact, it has been the lowest-quality small caps that have risen the most since the market’s bottom in March. The lowest quintile of the Russell 2000 ranked by return on equity—a key measure of quality—dramatically outperformed since the market bottom.
ROE is a measure of a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested, in percentage. It is calculated as trailing 12 month net income for common shareholders divided by average common total common equity.
Source: Bloomberg 2/19/20 to 7/30/20. The first quintile represents the top 20% of stock in the Russell 2000 based on Return on Equity (ROE), while the fifth quintile represents the bottom 20% of stocks by ROE.
It’s quite rational these days to look to shift one’s portfolio away from the dominant—and expensive—large cap tech and growth stocks. Flocking to the lowest-quality small cap stocks is, however, quite far out on the risk spectrum. Add some small caps, sure. The Russell 2000 is trading at roughly half the price-to-book value of the S&P 500, down from near parity a decade ago—which is kind of the point. The overall Russell 2000 certainly seems cheap enough. Taking advantage of that discount through a higher-quality approach may prove to be a more prudent path, particularly with a virus that shows no sign of going away anytime soon.
The price-to-book ratio compares a firm's market-to-book value by dividing price per share by book value per share.
All green in July.
We’re over halfway through Q2 earnings thus far, and investors have been watching results very closely for clues as to how corporate America’s fundamentals are holding up amidst the tenuous reopening progress. Results so far have been generally favorable, at least in terms of a high percentage of companies beating earnings and revenue expectations. But recall those expectations were lowered significantly earlier this year after impacts of the first wave of the economic shutdown were beginning to be understood. We like to look at actual year-on-year growth of earnings, as it gives important clues to the state of fundamentals.
As it stands today, the Q2 earnings decline for the S&P 500 is projected to be over 35%—the worst decline since 2008. And we note this comes on the back of an earnings decline of roughly 14% in Q1 2020, and essentially no earnings growth for all of 2019. The important point here is that sometime soon, companies will have to deliver earnings growth to support today’s lofty valuations. The S&P 500 is trading at around 22x forward earnings—well above 5- and 10-year averages. Yes, tech earnings have been good, but one sector can’t be expected to carry the market forever. Additionally, any further setback in the ability of companies to deliver those earnings from here could trigger more volatility.
One area of the market to potentially look at for some earnings resilience is high-quality dividend growth stocks. Historically, stocks that have grown their dividends over long periods of time have delivered more stable earnings streams, helping these companies weather market turbulence. This was on full display in Q1 when the S&P 500® Dividend Aristocrats®—a group of names from the S&P that have grown dividends for at least 25 years—delivered earnings that declined just 6%, much better than the market’s 14% decline. Thus far in Q2, the Aristocrats’ earnings have declined only about half as much as the overall market. And with price-to-book valuations in line with their historical averages, quality dividend growth may offer a relative bargain in an otherwise expensive market.
As impressive as the dominant run of large cap growth-oriented stocks has been, many investors are at least thinking of rebalancing toward other opportunities. Small cap stocks in particular have had a fairly good run since the big drawdown in the first part of the year, and in fact the Russell 2000 Index outperformed the S&P 500 during Q2.
Now, that’s not completely surprising considering that historically, small cap stocks have tended to outperform large caps after large market corrections. But there is one potential headwind that small caps could face for the near term—namely what has been driving the rally. In small cap land, the rally hasn’t been all about technology stocks with piles of cash on their balance sheets as it has been with large caps.
Remember that the IT sector does not dominate the small cap market like it does in the S&P 500—IT stocks represent only 15% of the small cap market versus over 25% for the S&P 500. Rather, as we show in the chart of the month, what has been driving the rally is the lowest-quality stocks as measured by return on equity. Note that these low-quality stocks were not hit any harder in the drawdown. This runup may be leaving them quite exposed to any potential setback in the economic recovery or any deterioration in fundamentals like earnings growth, which could hit those lower-quality names the hardest and put the brakes on the rally.
So, just like in large caps, owning quality small cap stocks carries a lot of appeal in this environment, and one simple way to buy quality is through a dividend growth strategy.
News that the Fed would purchase corporate bonds and fixed income ETFs marked the peak in what many are calling a “blowout” in credit spreads. After initially announcing a Corporate Credit Facility on March 23, a Secondary Corporate Credit Facility was announced on April 9. The combined Corporate Credit Facilities (CCF) were said to be as large as $750 billion and instilled confidence among investors in the bond market. The Fed’s action was aimed at helping to ease the access of funds for corporations experiencing hardship due to COVID-19 and as a result helped to lower the cost of credit. Upon reviewing the CCF thus far, however, it appears the Fed’s purchases have been far below $750 billion.
The Fed began the CCF in May as we saw the balance sheet item expand from $0 to $35 billion, but we have not seen much action since then. As of the end of July, the CCF stands at just $44 billion. Why haven’t we seen more corporate bond buying from the Fed? During the month of July, the CCF increased by just $2 billion. Is the Fed really doing everything in its power to support liquidity?
Source: Bloomberg. CCF shown in millions. Credit spreads as indicated by the Bloomberg Barclays US Agg Corporate avg OAS
The truth of the matter is that credit spreads are now just 32 basis points above where they were at the start of the year and prior to the COVID-19 pandemic. It is possible that the Fed has been able to accomplish its objective without exhausting all resources. Yields are at historic lows and continued to move lower during the month of July. Since the Fed’s announcement on March 23, the corporate bond market has rallied 20.32%.1 Perhaps all it took was the indication of support from the Fed to bolster the market. The good news is that the Fed still has plenty of legroom to continue its purchasing of corporate bonds and corporate bond ETFs. Bond ETFs made up $8 billion of the Fed’s balance sheet according to its June 30 filing. With wiggle room of $706 billion in additional CCF, investors may continue to be optimistic with respect to corporate bond performance even while news surrounding COVID-19 is fairly dismal.
1Sources: Bloomberg. As measured by the Bloomberg Barclays US Corporate Index
Source for data and statistics: Bloomberg, FactSet
The different market segments represented in the chart use the following indexes: U.S. Large Cap: S&P 500 TR; U.S. Large Cap Growth: S&P 500 Growth TR; U.S. Large Cap Value: S&P 500 Value TR; U.S. Mid Cap: S&P Mid Cap TR; U.S. Small Cap: S&P U.S. 600 SC TR; International Developed Stocks: MSCI Daily TR NET EAFE; Emerging Markets Stocks: MSCI Daily TR Net Emerging Markets; Global Infrastructure: Dow Jones Brookfield Global Infrastructure Composite; Commodities: Bloomberg Commodity TR; U.S. Bonds: Bloomberg Barclays U.S. Aggregate; U.S. High Yield: Bloomberg Barclays Corporate High Yield; International Developed Bonds: Bloomberg Barclays Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced.
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