Small caps are having a great year so far, but there are increasing worries that the good times might not last. The Russell 2000 is outperforming the S&P 500 by 3% (13% vs 10%) this year, but has tumbled in recent days, a troubling sign. What could be driving the losses is that the big gains in price have not corresponding to improving fundamentals. For instance, small cap performance is very tied to purchasing managers index data (PMI), but the rise in price has not been tied to changes in the PMI. Additionally, small cap companies tend to have the most floating rate debt, which puts them at a higher risk of rising rates. They also tend to have much lower credit quality, meaning they are the most susceptible to shifting rates. More than half the debt issued by small companies is rated as junk.
FINSUM: There is no reason to think the bottom is going to fall out here. However, a sense check seems necessary for small cap investors as there are significant risks.
With all the newfound reticence of the Fed, one important fact remains—they could hike at any time. The Fed was hawkish for a long time, and as dovish as they have suddenly become, a position shift on rates could be quick. Accordingly, when considering income-focused investments, advisors need to be very mindful about rate risk. One way to earn good income while also hedging against rates is to look at short term bond funds. Zero and short duration bond funds have little to no rate/duration risk, which means they can earn income without the threat of big losses coming from movements in rates and yields. Some funds to consider are the ProShares Interest rate hedge family or the Fidelity Limited Term Bond (FJRLX), the latter of which yields 2.89% and has a duration of 2.4 years.
FINSUM: Short-term yields have come up so much that limited term bond funds now look like a great buy for stable income without so much capital risk.
We have been tracking the economy closely looking for signs of the pending recession that everyone is so worried about. Labor market data last week set off a lot of red flags, and now things are on even more unsure footing. New data released shows that inflation rose at just 0.2% in February, representing an annual gain of 1.5% over the last twelve months. The low inflation means the Fed is not rushing, with Fed chief Powell commenting last week “With nothing in the outlook demanding an immediate policy response and particularly given muted inflation pressures, the [Federal Open Market] Committee has adopted a patient, wait-and-see approach to considering any alteration in the stance of policy”.
FINSUM: This just seems like a return to the post-Crisis norm that we have had. Maybe we will fall back into the several year mode where growth was 2% and inflation was 1.5%.
The whole market rally this year has pretty much been predicated on the Fed u-turning on rates. This makes sense, as it signaled that the Fed was not going to hike the economy into a recession. However, there are reasons to be nervous that the Fed may reverse course. One top economist thinks that the Fed may hike twice more this year as strong economic data will start to push Powell’s hand. US service industry data has been quite strong, and overall, “The fundamentals are not that bad. That could mean Powell has no choice but to hike.
FINSUM: We don’t necessarily agree with this view. While we are nervous about the Fed reversing course, we don’t think they will be under pressure to do so until inflation actually heats up.
Once you admit that this 2019 rally is almost purely predicated on the Fed dramatically turning around its position on rates and the economy late last year, you come to a realization: it could all end so quickly. The market is very vulnerable to the Fed’s actions right now, so the question becomes—will the central bank turn hawkish? The short answer is that it doesn’t look like the Fed will get hawkish any time soon. New language released in the latest notes look even more dovish than in December. The key buzzword is that the Fed is looking to be “patient” on rates and says it would need clear upward signs in the economy to hike any further.
FINSUM: The Fed has set up another goldilocks situation for markets. So long as data is okay but not too good, asset prices will be fine. If some data comes out poorly, the market knows the Fed can cut rates. Are we in for another big bull run?
Stock investors may have largely moved on from day to day concerns about a pending recession, but important parts of the bond market are still signaling a downturn is coming. For instance, the 1 to 5-year spread in Treasuries inverted at then end of December, and despite the Fed making a big policy u-turn, has remained inverted ever since. The spread is currently minus 7 basis points. It is important to remember that the entire yield curve does not invert at once, it happens in stages, and this particular measure has proven to be a good recession indicator in the past.
FINSUM: It is alarming to us that this remains inverted despite the drastic change at the Fed. From here forward we expect the curve to be very data dependent, as if economic data is worsening, we expect more and more of it to invert.