Fires, floods, and geopolitical unrest seemingly did not hold back the equity markets in August. Retailers held up their end of the bargain, wrapping up the S&P 500 second-quarter earnings season, generally keeping pace with the 16% positive surprise of the broad index. Modestly disappointing consumer sentiment and confidence readings were offset by a strong payroll report, increased capacity utilization, and solid ISM Services and Manufacturing reports. Inflation pressures and Fed tapering talks contributed to a modest rise in longer-term interest rates. The pace of the increase is likely to do damage to defenseless bonds whose coupons are fixed, but unlikely to hurt stocks whose earnings can grow. For investors looking beyond stocks and bonds, bitcoin’s rise (up over 20% in August) remained in the headlines, as more investors consider its potential role in their portfolios.
Equities remain the largest component of most investors’ risk asset allocations. Mid-cap stocks, however, may be the most overlooked equity segment. It’s an understandable oversight. The strong profitability of large-cap growth stocks has some investors seeing them as a sort of new defensive allocation. Investors also see the weak fundamentals and historical interest rate sensitivity of small-cap stocks, and think it reinforces the notion that there is no alternative to mega-cap growth (see last month’s market commentary for small caps worth considering). Consider, however, the case for mid-cap stocks.
Mid-cap stocks have had a great century—delivering roughly double the return of large caps, century-to-date. Large caps have largely outshined them over the last decade, though, driving down the relative valuation of both mid- and small-cap stocks.
Source: Bloomberg. Price-to-book and Return on Assets, as of 9/1/2021. Net debt to EBITDA, 2021 year-end estimate. Price-to-book value is the ratio of the price of a stock (or index) versus book value per share. Return on Assets is an indicator of a company’s profitability relative to its total assets, calculated by dividing a company’s net income by total assets.
The devaluation of mid- and small caps may have been a bit indiscriminate. While mid-cap stocks are trading at the same price-to-book multiple as small caps, they typically have substantially higher Return on Assets (ROA) and substantially less leverage. Higher ROA gives mid-cap stocks a potentially superior cushion if inflation pressures, margins and lower leverage limit their exposure to higher interest rates. We’ll leave the debate over the relative attractiveness of large- versus mid-cap stocks for another day, but for those prudently seeking options outside of the large-cap space, mid-cap stocks shouldn’t be overlooked.
U.S. Large Cap Growth topped the charts, with most equity market segments in the green. U.S. and international developed bonds suffered, but emerging market bonds were up.
Source: Bloomberg. August returns 7/31/21‒8/31/21, year-to-date returns 12/31/20‒8/31/21. Performance quoted represents past performance and does not guarantee future results.
Here’s a list of upcoming key economic releases, which can serve as a guide to potential market indicators.
In mid-August, the U.S. Senate passed a $1 trillion infrastructure bill that serves as a key policy objective of President Biden’s and represents the nation’s largest investment in our infrastructure to date. The wide-ranging bill would provide funds for roads and bridges, thousands of miles of new power lines, water system upgrades, and renewable energy initiatives. The bill now awaits a vote from the House.
Simultaneously, governments around the world have been introducing legislation to help their countries reach ambitious energy emissions reduction targets, most with the long-term goal of becoming carbon neutral. The infrastructure that underpins the transportation, transmission, and storage of various forms of energy will likely be a key enabler to achieving a cleaner and more sustainable future.
Taken together, these two catalysts have generated much investor interest in infrastructure as of late. Infrastructure companies that own and operate essential assets that societies rely upon could be a potential investment opportunity, offering attractive risk-adjusted returns and a compelling yield.
Not all infrastructure companies are the same. As a group, companies that build or develop infrastructure—construction companies, raw material producers, airline manufacturers and the like—tend to be more volatile and prone to boom and bust cycles. When times are good, their revenues and earnings may increase, only to falter when the economic cycle cools.
In contrast, pure-play infrastructure companies—those that own and operate infrastructure assets, such as airports, cell towers and the like—are different. These assets are essential and large-scale, often with limited competition, and despite the aberrant events of the pandemic, they have consumer demand for their services that tends to be inelastic. These characteristics generally make the business models of pure-play infrastructure companies less cyclical. As a result, the infrastructure bill may provide benefits to companies that build or develop infrastructure in the near term, but its longer-lasting impacts could benefit pure-play companies.
These critical differences have resulted in contrasting risk and return profiles over time. Pure-play infrastructure, as represented by the Dow Jones Brookfield Global Infrastructure Composite Index, has delivered slightly higher risk-adjusted returns over cyclical infrastructure. The “ride” experienced by cyclical infrastructure investors, as represented by the Indxx U.S. Development Infrastructure Index, has been very different. While there are no guarantees for future results, this could prove beneficial following the strong market rally from the pandemic lows of 2020 and the uncertainty still ahead.
Source: Morningstar. Data from 2/01/11‒8/31/21. Sharpe Ratio is a measure of risk-adjusted returns. Standard deviation is a measure of the volatility of a portfolio’s returns relative to its mean.
In a yield-starved market, publicly traded (listed) infrastructure owners and operators have generally provided an attractive income stream, supported by stable cash flows. Many investors could be well served to focus on income-generating infrastructure assets that may be strengthened by government actions and a successful vaccine rollout.
Record-low interest rates have created challenges for income-seeking investors. With current 10-year Treasury rates hovering well below 2%, traditional sources of yield, such as fixed-income investments, may be inadequate. Investors have therefore looked to alternative sources of yield, like high dividend-yielding equities, to enhance their portfolios’ income generation capabilities.
However, risks abound. Typically, stretching for yield can lead to poor outcomes if investors focus on stocks that may not be able to sustain their dividends in times of economic hardship. When stocks cut their dividends, poor performance often follows, as was largely the case during 2020. In contrast, pure-play infrastructure stocks—companies whose business is primarily owning or operating infrastructure assets like toll roads, electricity-transmission networks, airports, and water supply systems—have typically generated long-term cash flows regardless of the economic environment. This could make them a potentially compelling source of yield for investors, although it should be noted that there is no guarantee of income.
Source: Bloomberg, yields as of 8/31/21. U.S. Large Cap Stocks by the S&P 500, International Developed Stocks by the MSCI EAFE Index, High Yield Stocks by the S&P High Yield Dividend Aristocrats Index, and Global Infrastructure by the Dow Jones Brookfield Global Infrastructure Composite Index.
The fixed income market struggled during the month of August, with the U.S. aggregate bond market falling 0.19% as measured by the Bloomberg U.S. Aggregate Bond Index. The yield curve steepened slightly, while investment-grade credit spreads remained stagnant and high-yield spreads tightened 9 basis points (bps). As a result, longer duration fixed income segments, such as the corporate bond market, saw the largest draw on returns. Of the fixed income segments evaluated below, the corporate bond market was the most likely to be adversely impacted from rising rates due to its extended duration, standing at 8.7 versus the broader U.S. bond market at 6.7, as of August 31.
Inflation seems to be all the Fed can talk about lately. During the Jackson Hole Economic Policy Symposium, where key central bankers and policymakers met last month, Fed chair Jerome Powell reiterated his stance that the recent spike in inflation is transitory. We’ve heard this repeated from the Fed ever since both year-over-year CPI and core PCE began to spike several months ago. Their latest readings for July stand at 5.4% and 3.6%, respectively. During Powell’s roughly 20-minute speech in Jackson Hole, he mentioned inflation 65 times according to a transcript provided by Rev. The term “overcompensating” may come to mind, leaving some investors concerned with just how much emphasis the Fed has put into tempering inflation expectations.
CPI is the Consumer Price Index and is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. Core PCE is the Personal Consumption Expenditures Price Index, Excluding Food and Energy. The core index makes it easier to see the underlying inflation trend by excluding food and energy, for which prices tend to swing more dramatically than other prices. Core PCE is the Fed’s preferred inflation measure.
Should investors be concerned about continued inflation? The key here is that the Fed has a variety of tools to utilize in order to temper inflation, including both tapering its asset purchase program and increasing the Fed Funds rate. By tempering inflation expectations, the Fed is also tempering expectations of dramatic monetary policy shifts. Policy officials are likely trying to avoid a taper tantrum, like the one seen in 2013. For some history, on May 21, 2013, then-Chairman Bernanke announced plans to begin tapering the Fed’s asset purchase program following the global financial crisis. After the announcement, the 10-year Treasury yield rapidly rose more than 100 bps over the following months.
Source: Bloomberg. Data from 5/21/13–9/3/13.
This time around it appears the Fed is trying to give sufficient notice as to the timing of the end of quantitative easing, likely in an attempt to avoid what occurred in 2013. Nonetheless, the Fed has continued to indicate that it will likely reduce the size of its asset purchases sometime this year, so long as the economy stays on track. As a result of its efforts, the speed at which the 10-year Treasury rises may be reduced; however, we are still likely to see them rise from the suppressed levels they have been at since the onset of the pandemic.
Fixed income investors may be wise to reassess how much interest rate risk they are taking on, specifically within the corporate bond component of their portfolios, given the corporate bond market’s extended duration at this time.
Sources for data and statistics: Bloomberg, Morningstar, ProShares.
The different market segments represented in the performance recap charts 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: Russell 2000 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 U.S. Aggregate; U.S. High Yield: Bloomberg Corporate High Yield; International Developed Bonds: Bloomberg Global Agg ex-USD; Emerging Market Bonds: DBIQ Emerging Markets USD Liquid Balanced.
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This is not intended to be investment advice. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.
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Bonds will decrease in value as interest rates rise. International investments may also involve risks from geographic concentration, differences in valuation and valuation times, unfavorable fluctuations in currency, differences in generally accepted accounting principles, and economic or political instability. In emerging markets, many risks are heightened, and lower trading volumes may occur. Small- and mid-cap companies may lack the financial and personnel resources to handle economic or industry-wide setbacks and, as a result, such setbacks could have a greater effect on small- and mid-cap security prices.
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