Top Weekly Themes
- Small cap stocks finally have their day in the sun – The underperformance of small cap equities, especially value stocks, relative to their large cap counterparts has been staggering over the past 12 months ending last Friday. Over that time period, the Russell 2000 Value Index (small cap value) lagged the Russell 1000 Growth Index (large cap growth) by nearly 4600 basis points (46%!). Based on the data we reviewed, this negative return differential has only been more extreme during the late 1990’s at the height of the dotcom bubble. Last Monday, 5/18 the tables were turned with small cap value outperforming large cap growth by over 5.50% in one trading session. There have been significant divergences in equity returns between investment styles, but this return spread on 5/18 was an outlier to say the least. Over the past 25 years, there have only been three other days when small cap value outperformed/underperformed large cap growth by a wider margin. Large deviations in investment style returns often occur during various phases of bear markets and are not necessarily an indication of a directional shift favoring one asset class over another. However, we have previously highlighted the extreme valuation discrepancy between large cap growth stocks and several other equity asset classes. One data point does not make a trend, but at least for this week the market seems to think our observations are not completely unfounded.
- Housing market decline is comparable to 08/09 Great Recession – Housing Starts, Building Permits, and the NAHB Housing Market Index (homebuilder survey) data was released last week. Unfortunately, the housing market, which has been on the mend for the last several years, is not impervious to the economic shock caused by Covid-19. There has been some improvement in more current housing market indicators, such as mortgage applications and ShowingTime’s real estate activity index; however, abrupt weakness in housing makes a v-shaped economic recovery less likely in our opinion. During the last downturn, it took the housing market several years to recover and was one of many factors that caused economic growth to fall below levels seen in prior expansions. So why own REITs if the housing market continues to struggle? The reason is that REIT equity returns do not necessarily move in tandem with widely followed housing market data points. In addition, there are many businesses categorized as REITs (Industrial, Infrastructure, Data Center) that are not affiliated with retail housing.
- More government fiscal stimulus seems likely – On Friday, May 15, the US House of Representatives passed a $3 trillion stimulus bill (“Heroes Act”) that would include a wide range of benefits to households, businesses and state governments. Although there will likely be considerable deliberation and bartering with the Senate and the Trump Administration, we think it’s inevitable that another stimulus bill gets passed – barring an abrupt end of the Covid-19 pandemic. We think fiscal measures are warranted to offset the decline in personal income and will help stabilize the economy. However, the investment ramifications are less conclusive from our perspective. It’s difficult to ascertain the “winners” and “losers” and whether more government intervention leads to increased productivity and sustainable growth over the long-run. This is just another example of why we think it’s imperative to have a diversified portfolio where investment success/failure does not hinge on the outcome of one macro event.
|Equities||Week (%)||YTD (%)||1-Year (%)||3-Year (%)||5-Year (%)||Div Yield (%)|
|Russell 1000 Value||6.12||(18.81)||(8.52)||4.58||18.25||3.06|
|Russell 1000 Growth||5.34||3.32||20.72||61.28||91.63||1.08|
|Bloomberg/Barc US Aggregate||0.45||5.13||10.47||15.98||21.75||1.37|
|Bloomberg/Barc US High Yield||1.38||(6.94)||(1.70)||7.32||20.77||7.59|
|Bloomberg/Barc Muni Bond||0.91||0.52||3.68||11.81||19.92||1.75|
|Bloomberg/Barc Global Agg. Ex U.S.||0.73||(0.84)||3.38||7.42||13.08||0.85|
|Crude Oil (WTI) ($/bbl)||30.41||(45.15)||(47.02)||(33.91)||(43.22)||33.49|
|Natural Gas ($/mmbtu)||9.59||(19.10)||(33.74)||(45.61)||(39.25)||1.77|
|Currencies||1 Week Ago||YTD||1-Year Ago||3-Years Ago||5-Years Ago||Current Level|
As of May 20, 2020 (close)
*Dividend Yield For MSCI EAFE and MSCI EM are from 4/30/2020.
Chart of the Week
- Since the Federal Reserve (Fed) announced its Corporate Credit Facility program in early April, which enables the central bank to purchase corporate bonds directly, asset flows into non-investment grade (“junk”) bonds have been robust. According to data provided by Refinitiv Financial Solutions, one of the largest non-investment grade corporate bond funds, SPDR Bloomberg Barclays High Yield Bond ETF, has had asset inflows of close to $5 billion over the past few weeks. As highlighted in the chart above, credit spreads have contracted significantly from the highs seen at the end of March/early April.
- Credit spreads can rise dramatically during the later phase of a business cycle as the next recession gets underway. However, the dramatic widening of spreads this cycle was quite unusual. Even during the 08/09 Great Recession, spreads began to widen for several months before eventually blowing out to record levels. This is just another data point that shows the rapid deterioration caused by Covid-19.
- In each of the past two recessions, you can see that spreads widened initially, then contracted, and finally moved higher during the final stage of the recession or equity bear market. Will history repeat? We don’t know for sure, but we would not be surprised to see some spread widening in the below BB rated space as the virus’ effects on corporate profitability fully manifest over the next few months.
- Is the “don’t fight the Fed” mantra alive and well? For now, it looks as the Fed’s efforts have put a ceiling on spreads, which is one of the reasons we have been trying to take advantage opportunities in the investment grade bond space. However, there are still concerns we have about the lasting impact of Covid-19 that has not caused us to materially increase exposure to the non-investment grade space.
The Equity Market Is Signaling that the Worst is Behind Us
- We are not investment professionals masquerading as epidemiologists and cannot model out the likely course Covid-19 will take. Even experts in the health care field cannot come to an agreement in terms of the trajectory of future cases. In addition, economists as well as financial market pundits have varied forecasts regarding what future economic growth and corporate profits will resemble over the foreseeable future. There are too many unknown variables, especially given the infrequent nature of pandemics. This is arguably the worst pandemic since the Spanish Flu of 1918, although there are clear differences in the infectious and case fatality rates today relative to the events that unfolded over 100 years ago.
- The charts above show data provided by the Center for Infectious Disease Research and Policy at the University of Minnesota and the possible paths of Covid-19 cases over the next couple of years. The charts above could be considered a form of fear mongering, and some people will likely argue that while Covid-19 poses a significant health risk, the effects of the coronavirus are not as bad relative to the headlines propagated by the media. It is also possible that worst is clearly behind us. We are encouraged to see some states reopening economic activity as the number of reported cases has started to wane.
- Financial markets, which could very well be right, are discounting a favorable outcome given the dramatic rise off the March 23rd low (>30%). From our perspective, the rally we’ve seen seems to assign a very low probability of a second wave of Covid-19 infections (see chart 2). It is possible that many more people have contracted the coronavirus relative to what has been reported given the asymptomatic nature for a considerable number of people that were inflicted. However, we do think the potential of a 2nd wave, or periodic spike in cases, is being overly downplayed by the markets. Therefore, we don’t believe it’s advisable to increase risk exposure at this juncture.