Rate cuts are going to send shares higher and bond yields lower, right? A win-win for portfolios. Not so fast, as the effect a Fed cut will likely have on portfolios could be anything but predictable. The truth is that monetary easing is not the economic steroid it once was, and investors know it, so the odds of a pop in the market seem low. This is doubly true because much of the possible gain from rate cuts has already been priced in by the market due to how well the Fed has telegraphed this move. If any stocks should do well, it would be small caps, which are more reliant on borrowing and thus would gain the most from lower rates.
FINSUM: This cut has been so anticipated that it will likely be greeted by a shrug. If anything, we think there are more downside risks.
The broad expectation is that rate cuts will boost all bonds. To some degree this is likely true. However, not all bonds will be affected to the same degree. For instance, safe bonds—think investment grade corporates and Treasuries—have likely already seen most of the gains they will. But high yields are a different story, as they are much more likely to see a decent rally, as lower borrowing costs are a bigger boon to those companies and the cuts themselves will help sustain the economic cycle, which is more important for them than for ultra-safe companies.
FINSUM: This seems to be pretty good analysis. This rate cut has been widely projected and safe bonds have already seen gains, so junk may be the biggest beneficiary.
The muni market seems healthy. Other than the cases where budgets are exploding, the market as a whole has characteristically low yields and looks stable, especially because of excess investor demand from the recent tax changes. However, there are structural concerns about the market. Nuveen and Vanguard have come to dominate the market through their funds, sucking up to two-thirds of all the Dollars flowing into the market in the last decade. This is because investors have been increasingly buying muni funds, not individual securities. However, according to UBS, this is a big risk. “When everyone runs for the exit at the same time…no one wants to be the buyer of last resort … The concentration in large municipal asset managers will have ramifications during volatile times in that it will make the swings greater one way or another”.
FINSUM: Everyone has been warning about big runs on fixed income funds in a market downturn, but evidence of such has yet to materialize.
Barron’s has published an interesting article which argues that there are ten asset bubbles waiting to pop in markets. According to an analyst cited in the publication, further coordinated global central bank easing is likely to exacerbate these bubbles and turn a “run-of-the-mill recession into a full blown financial crisis”. The ten asset bubbles cited are in the following asset classes: US government debt, US corporate debt, US leveraged loans, European debt, Bank of Japan Balance sheet and related equity holdings, unprofitable IPOs, crypto and cannabis, growth and momentum stocks, software and cloud stocks, ETFs (especially fixed income).
FINSUM: So the whole world is in a bubble except the asset class that most people pay the most attention to—US stocks. The thing about many of these “bubbles” is that the economy is still plenty healthy to cover them (such as companies’ ability to cover interest etc).
Small caps socks are having a rough year relative to the S&P 500. The Russell 2000 is up 15%, but behind the 19% gain of large caps. However, one area of small caps is doing great—momentum small caps, which are ahead of even their large cap cousins. Funds like the Invesco DWA SmallCap Momentum (DWAS), are up 26% this year through Wednesday. The fund aims to match the performance of the best 10% of stocks in the Russell 2000. Speaking broadly on the performance, the head of research at Nasdaq Dorset Wright says “Momentum can thrive in a market where you have a wide range of dispersions, and that’s especially true in the small-cap space, where you can have a big difference between the best and worst performers”.
FINSUM: There is a quite a variance in performance and financial conditions of small cap companies, and given the prevailing environment, that is creating highly differential results, which is great for momentum funds.
Falling yields are having a very positive effect on gold. The metal is already enjoying its best first half in years, and the fundamentals for gold look solid. Potential weakness in equities and worries about growth are both stoking gold demand, while lower yields and a weaker Dollar are also supportive. Gold is now being used as a hedge against equities in a way that bonds have traditionally been employed. “The bond market is not acting as a reliable hedge against equity weakness in the way that everyone expected it to and it hasn’t operated that way since 2008. Gold is providing better protection against potential equity weakness right now than bonds are”, says the head of gold strategy at State Street Global Advisors.
FINSUM: Gold seems like it has a nice path to keep its performance going. That said, we are worried rate cuts might spark a more risk-on equity market, which would pull money out of the metal.