The risk-on-trade returned with a vengeance in June, as expectations for a Fed rate cut and cooling trade tensions drove a substantial rally across all asset classes.
- The S&P 500 rose just over 7%—more than erasing May’s selloff.
- The U.S. saw weakening but still expansionary economic indicators, with global indicators weakening notably as well.
- U.S. Treasury yields continued to drift lower even as risk assets rallied, and inflation remained stubbornly low.
After three decades of outperformance, mid cap stocks have lagged for more than two years and now trade at more than a 35% discount (price-to-book) to the S&P 500.
Source: Bloomberg. Ratio shown is the S&P 400 MidCap Index price to book divided by the S&P 500 price-to-book.
Stocks rallied, credit spreads narrowed, commodity prices rose, and U.S. Treasury yields drifted lower—resulting in positive returns across all asset classes.
June’s strong equity market returns were indeed a reminder of how low interest rates support stock prices. But with the added tailwind of de-escalating trade tensions, stocks are becoming closer to fully valued. At the end of May’s selloff, given the low level of interest rates, one could have argued that the S&P 500 was 10% to 15% undervalued. Roughly half that discount is gone now. International stocks are certainly cheap, but weak economic conditions nearly everywhere in the world—even in Germany—could suggest “value trap” more than value. If the asset allocation answer is, therefore, benchmark weight U.S. large cap stocks and underweight international stocks, the overweight opportunity could be U.S. mid cap stocks.
For nearly three decades (12/31/90 to 7/1/19), U.S. mid cap stocks outperformed the S&P 500 by cumulatively 1200%, earning them the title of the “sweet spot” of the equity markets. Since the end of 2016, however, mid caps have lagged the S&P 500 by around 16%. As noted in our chart-of-the-month, mid caps now trade at over a 35% discount (price-to-book) to the S&P 500 compared to parity in 2011 and an average discount over the last decade of less than 15%. While similar observations can be made about small cap stocks, the Russell 2000 is historically a more volatile choice, and the lower quality of small cap stocks—low profitability and high debt levels—may leave them more exposed in the event conditions deteriorate more than, and sooner than, expected.
It’s hard to fault investors who see increased odds of a Fed rate cut—along with a further drifting down of longer-term U.S. Treasury yields—as indications that the coast is clear to invest in those longer-duration U.S. Treasuries. Beware of complacency. More often than not, when the Fed has cut interest rates, the yields on the U.S. 10-year Treasury rise—and prices fall.1 After all, one of the key reasons the Fed cuts the Fed Funds rate is to increase inflation expectations, which is a key driver of longer-term interest rates. That’s especially true right now with the core Personal Consumer Expenditure (PCE) Deflator running at 1.6%, below the Fed’s target of 2%.
1 In the one-year period subsequent to a quarter where the Fed Funds rate has decreased.
The core Personal Consumer Expenditure (PCE) Deflator index measures the prices paid by individuals for goods and services, excluding food and energy.
Short Duration May Be the Way to Go
There’s of course no guarantee this would happen. The Fed may put a stop to the shrinking of its balance sheet. The Fed’s large balance sheet—a core manifestation of quantitative easing—has been one of the factors suppressing longer-term interest rates. But the Fed’s balance sheet is already smaller than it was when the 10-year U.S. Treasury Yield hit its all-time low of just under 1.5%. And the yield curve is still inverted, which rewards the risk of longer-duration bonds with lower yields. Given this, investors may turn toward investment in shorter duration bonds.
Source for data: Bloomberg.
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