The 2nd quarter of 2018 shared certain macroeconomic and market themes with the 1st quarter. However, there were new developments too that manifested in sector and style equity returns during the quarter.
The US dollar reversed its 5-quarter streak of depreciation, and turned sharply higher against most currencies. The bottoming and then sharp ascent of the US Dollar Index began towards the end the 1st quarter. While some commentators have attributed this development to the widening yield spreads between US treasuries and other sovereign bonds (causing the former to be more attractive to international investors), others have cited the increased rhetoric around trade wars and tariffs. This is likely suggestive of the fact that the US holds the upper hand in any negotiation around trade issues with its partners.
Trade Conflict Escalation
In line with the above point, the imposition of tariffs and announcement of future tariffs have particularly been felt in industries such as Steel (+), Capital Goods (-), Automotive (-), and Semiconductors (-). Further, the US dollar appreciation referenced above proved to be a headwind to companies (many of whom are in the sectors that were negatively impacted by a potential trade war) that relied primarily on exports for their revenues and earnings. The Automotive and Semiconductor industries have enjoyed solid returns over the prior 2 years. However, the lower returns during the second quarter (especially during June), manifested as a reversal of the price momentum factor that is a component of Affinity’s multi-factor model.
Small Caps Outperform
A rising US dollar favors importers, and domestically-oriented companies. Generally, the small cap companies tend to be domestically-focused. In the second quarter of 2018, small cap stocks far outpaced the returns of large and mid-cap companies. During the quarter, the Russell 2000 Index posted a robust return of 7.75% versus 3.57% and 2.82% for the Russell 1000 Index and Russell Mid Cap Index, respectively. This has coincided with significant strength in small cap equity performance relative to larger companies. Small cap companies are generally better protected from the strength of the US Dollar since a greater percentage of a smaller firm’s revenues are generated domestically.
Long Bond Yields Were Flat
The yield on 10-year Treasuries bottomed near 2% in September 2017, and appreciated by a further 1% by the 1st quarter. However, despite all the talk of a ‘rising rate environment’, the yield on the long-bond pulled back, and ended the quarter below 3%. On the short end of the curve, the Federal Reserve continued its rate hikes – they have hiked twice thus far this year. This has led to a rise in yields on short-duration Treasuries such as the 3-month and 2-year tenors, leading to a compression in spreads between the short and long maturity Treasuries. The so-called ‘flattening of the yield curve’ – currently, the gap between the 2-year and 10-year Treasury yields is approximately 0.25% – has been extensively reported in the financial media, with much debate about the likelihood of a recession. While we do subscribe to the notion that the bond market might be signaling lower economic growth in the future, we also note academic research that a necessary condition preceding prior recessions was an actual inversion of the curve – where short-dated yields exceeded long-dated yields. That condition has not been met yet, and hence we hesitate to join with those expecting an imminent recession. We did note that the Financials sector experienced subdued equity returns during the quarter – a likely consequence of the movement of interest rates.
That said, there were a couple of trends that were common to the 1st and 2nd quarter of the year.
Energy Prices Appreciate
According to Bloomberg, spot prices for WTI crude and Natural Gas gained nearly 10% during the quarter, building on the 8% gain for WTI during the 1st quarter. This resulted in the Energy sector being the best performing sector during the quarter. Prices, as we were taught in Econ 101, are determined by supply and demand. The supply side of the equation is governed by OPEC production cuts along with reduced output from countries such as Venezuela. However, a more recent development is that OPEC is going to increase output in the future. The demand side of the equation is supported by a robust US economy. Labor markets remain healthy, corporate earnings are improving and tax reform benefits are contributing to consumer and corporate spending. While firms in the Energy sector did benefit from the rise in oil prices, there were warnings by airlines and cruise line companies that their exposure to rising jet and marine fuel prices respectively, would weigh on future earnings.
The market’s rise in the 2nd quarter was driven in part by rising profits and a positive outlook for economic growth in the near term. The rise was muted by concerns about changing economic policies and a decrease in expectations for real growth going forward. By the end of the quarter, forecasts for real growth during the 2nd quarter had fallen, and real growth in the 3rd quarter is now forecast to be 3.0% at an annual rate. These estimates were produced by a survey of approximately 60 economists conducted by the Wall Street Journal. While 3.0% real growth is still reasonably attractive, a decelerating growth rate could moderate corporate profits in the second half of 2018 and into 2019.
The current administration has shown a willingness to raise tariffs broadly in the face of what it believes are “unfair” tariffs imposed by trading partners on our exports. The announced goal is to move to a new tariff regime, with a generally lower level of tariffs. While lower tariffs would be beneficial, at this time, the dominant response on the part of our trading partners has been to raise their tariffs further. There is no evidence that a move to lower tariffs will occur in the near future. Increased tariffs have much the same impact on economic conditions as do increases in tax rates; they tend to raise the cost of real output and lower the amount of output. While the prospect of lowered real output is worrisome to market participants, it is easy to overestimate the damage increases in tariffs will produce.
We remain constructive on the U.S. equity markets, but are more optimistic about the prospects for smaller companies in the second half of the year. A strengthening US Dollar, particularly in the context of increasing worries overseas, might be a headwind for large cap companies that procure a significant proportion of their revenue and earnings from overseas. While we do not see a recession looming in the near term, we recognize that risks exist in the marketplace that warrant some greater level of caution. We employ several tools to manage portfolio risk. Perhaps the most important is valuation. While investors have not been rewarded for emphasizing attractively priced stocks this year, the portfolio is nonetheless well positioned. The portfolio continues to hold a significantly lower forward P/E relative to the S&P 500 Index.