The data is not all bad, but it’s not all good either. Equity markets across the globe continued to rise in August. On the good side of the ledger: another strong ISM manufacturing survey, a hot housing market and a better than expected second quarter corporate earnings season. On the bad side of the ledger: consumer confidence hit a six-year low, the retail recovery slowed and Washington persisted in its stalemate over stimulus.
One of the most important pieces of non-coronavirus news during the month was a change in Fed policy that Chairman Jerome Powell called a “robust updating.” The Fed is now more likely to tilt its policy toward keeping unemployment low and tolerating a bit more inflation. The announcement helped contribute to the equity market’s continued rise, but its impact was also felt in a steepened Treasury market yield curve.
Large-cap stock’s run of outperformance over the last decade1 has prompted many investors to consider tilting their portfolios toward small-cap stocks. The case for small caps is indeed a reasonable one. Expansionary monetary policy and economic recoveries have historically been beneficial to small caps. An unsung hero, however, has been mid-cap stocks. For three decades, from 1990 to the present, mid-caps have outperformed both large- and small-cap stocks by substantial margins (about 1.5% and 2% per annum respectively)2. Of course, that outperformance did not come in a straight line.
Source: Bloomberg, from 6/30/00 to 8/31/20. The price-to-book ratio is a measure of valuation that compares a company’s stock price per share by its book value per share, which is tangible assets minus liabilities. Performance represents cumulative returns. Past performance is no guarantee of future results.
Nearly a decade of large-cap outperformance has driven down mid-cap valuations to roughly half the price-to-book multiple of large caps. The last time mid-cap prices were this low was 2000—and during the decade plus of mid-cap outperformance that followed. While 2020 is not the same as 2000, the mid-cap opportunity deserves consideration. Another point in favor of mid-caps: They currently have considerably better fundamentals than small caps. Over the past 12 months thru August, while the Russell 2000 has tallied up negative profit margins and negative return on assets in aggregate, the S&P MidCap 400 has been in positive territory. For investors shifting some of their assets away from large-caps stocks, it could be wise to consider moving money into mid as well as small caps.
All green in August.
Strong equity returns in August—during which large-cap stocks were positive almost every day—has us asking a question that seemed unthinkable just a few short months ago. Is the worst behind us for now? After all, we are coming out of an earnings season that, while down from last year, exceeded most analysts’ expectations. Many companies are raising guidance again. And the Fed announced a dovish policy shift that essentially codified a strategy of allowing higher levels of inflation than previously targeted, which on balance should further support risk assets like equities.
Another piece of evidence that the markets are potentially assuming a more “normal” pattern is that volatility levels have declined. In fact, realized volatility for the month of August fell to its lowest level since January 2020. And as of 8/31/2020, it is at a level below its long-term average. Near-term headwinds like the ongoing pandemic and an upcoming election aside, the perpetual wall of worry perhaps seems like it could be a little less imposing these days.
Make no mistake about it, the rising market has not lifted all boats. Stark contrasts remain across market caps, styles and sectors. Small-cap stocks are still underperforming large caps by a wide margin. And despite being positive on a year-to-date basis through August, only three S&P 500 sectors are outperforming the index itself, which provides more evidence that a relatively smaller portion of stocks are doing most of the heavy lifting. Technology stocks, consumer discretionary (with a rather large assist from Amazon) and communication services have been winning. Eight other sectors are trailing, however, and energy and financials in particular have suffered large losses year to date through August.
The gap between the winners and losers, known technically as dispersion, remains large. The performance gap between tech stocks and energy stocks from YTD stands at a staggering 75%. Even within thematic strategies, which have captured a large mindshare of investor interest this year, there is a rather large performance divide. Strategies focused on themes like cloud computing, pet care and changes in the way consumers shop have posted strong returns. Maybe that is the underappreciated risk in this market—which strategies among this year’s winners are likely to see sustained outperformance?
Another example of the divide between the winners and losers can be found in what we have been referring to as retail disruption. As more consumers buy more of their everyday goods through online retailers, it is coming at the expense of traditional bricks-and-mortar retailers. This dynamic isn’t new of course, but it has been accelerated by the pandemic. The difference in performance is stunning. According to Bloomberg, the ProShares Online Retail Index returned 83.1% from 1/1/2020 to 8/31/2020, while the Solactive-ProShares Bricks and Mortar Retail Store Index lost 0.7%. As to the durability of this divide, the latest quarterly e-commerce sales report from the U.S. Census Bureau provides some interesting clues. Despite the large gains e-commerce has made, its percentage of the total retail sales pie as Q2 2020 represented just over 15%, implying a long runway for possible continued growth.
Source: US Census Bureau E-commerce Report, Q2 2020.
As noted previously, the Fed made headlines this month as it shifted its policy with respect to inflation. Though the target level remains the same, the Fed has acknowledged that periods of below-target inflation—which we have experienced for quite some time now—may be followed by periods of above-target inflation as it aims for longer-term inflation of 2%. This could mean that the Fed will allow inflation to tick above 2% for an extended period of time in the future prior to raising the Fed Funds rate.
In May, during the heart of many stay-at-home orders, year-over-year inflation dipped all the way down to 0.1% as measured by the Consumer Price Index. It has risen back to 1.0% as of the latest report in July. Inflation is one of the risks associated with bonds, as it can chip away at the real (or inflation-adjusted) value of coupon and principal cash flows received in the future. This is of particular concern for longer-dated bonds as the compounding effects of inflation increase.
Treasury Inflation-Protected Securities (TIPS) have garnered attention this year, as the principal value of TIPS increases when inflation rises. The coupon payments are at a “fixed rate.” But that rate is based on the adjusted principal amount, so the payments increase as inflation rises. Some fixed-income investors had anticipated the change in policy by the Fed, and long-term inflation expectations have been on an uptick since market participants’ inflation expectation for the next 10 years bottomed out on March 19.
Source: Federal Reserve Bank of St. Louis, 12/31/19—8/31/20.
Long-term TIPS (15+ years) have rallied 29% since March 19, as bond investors sought protection from potential inflation.3 The broader TIPS market, which includes both shorter-term and longer-term securities, is up over 14% while the Treasury market is up just over 3%4 during the same period.
Many investors may be unaware that, while TIPS offer protection from increases in expected inflation, they still have duration risk. During the month of August, we saw a steepening of the yield curve as longer-term rates rose. As such, longer-term TIPS (15+ year) were negative for the month of August. The 15+ Year TIPS index has a duration of approximately 22 years, drastically higher than much of the bond market.5 While short-term rates may stay low, recent movement of the yield curve indicates that this may not be the case for longer-term rates if they continue to rise toward more normal levels.
Interest rates do not change in lockstep with changes in expected inflation. From 7/8/16 through 11/8/18, the 10-year Treasury yield rose 188 bps. While there was an increase in expected inflation during this period, it was not as large as the yield increase. In other words, expected real rates increased. During the period, the investment grade interest rate–--hedged index—which specifically hedges the risk of rising interest rates—significantly outperformed 15+ Year TIPS and short-term bonds. Investors, who perhaps mistakenly believed that TIPS provided protection from rising interest rates, were likely disappointed.
Source: Bloomberg, 7/8/2016 – 11/08/2018.
To paraphrase an old investing adage: Know what you are protected from. If you are specifically concerned about rising inflation expectations, TIPS can be an effective choice. If you are concerned about interest rates rising from the current historically low levels, interest-rate hedged corporate bond strategies may make sense. And if you are worried about both, perhaps you should consider a blend of both approaches.
1Source Bloomberg: 03/31/2011 – 8/31/2020.
2Source Bloomberg: 12/31/90 – 8/31/20, S&P 500, S&P 400, Russell 2000 Index.
3Source: Bloomberg, as tracked by the ICE BofA 15+ Year US Inflation-Linked Treasury Index, 3/19/20—8/31/20.
4Source: Bloomberg, broader TIPS market as tracked by the ICE BofA US Inflation-Linked Treasury Index, Treasury market as represented by the Bloomberg Barclays US Treasury Index.
5Source for duration: Bloomberg, as of 8/31/20.
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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