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May flowers bloomed in the equity markets here in the US as the S&P 500 and Down Jones Industrial Average returns solid growth of +2.41% and +1.41% respectively. Even more impressive was the continued outperformance of smaller companies (especially in the tech sector) with the Russell 2000 returning +6.07%1.
The month ended with some whipsaw days driven mostly by the Italian political turmoil from the rejection of the establishment in favor of the populist movement; the issues lying namely around the euro and immigration. This political shift created a scare in the sovereign debt markets. In response, the yields on Italian bonds sky-rocketed to a four year high. Fears of Italy leaving the EU were somewhat diminished with the newly-formed government and markets and yields recovered most of their moves. We will continue to watch as events unfold2.
We attribute much of the smaller company outperformance of larger US companies to fiscal stimulus and less exposure to the dollar strengthening. On average, smaller companies tend to pay more in taxes than larger companies. One of these reasons is because they are more domestic in nature and therefore cannot shift cash overseas to avoid taxes. Smaller companies (represented by the Russell 2000) have a median effective tax rate of 31.9%, while larger companies (represented by the S&P 500) pay closer to 28%3. Therefore with the tax reform, the fiscal stimulus tends to give smaller companies a greater benefit. Additionally, because these smaller companies are more domestic in nature, their revenue is not as exposed to a strengthening dollar (which hurts their overall revenue) than their larger company counterparts. Roughly 20% of revenue for small companies comes from overseas, while between 30% - 40% come from larger companies4. Finally, because smaller companies are more domestic in nature, they tend to have less negative impact from trade tariffs. We continue to look for small cap stocks to outperform larger stocks this year, even with us being so late in the cycle.
Markets in emerging countries have probably had the hardest run this year, with June being no exception. In May the MSCI Emerging Market index lost -3.54% of its value as the US Dollar continues to provide headwinds. That being said we continue to look at emerging markets favorably, understanding that it will be volatile with a strong dollar. We believe emerging markets are much further behind us in their economic cycles and therefore poised much more for economic expansion. As emerging economy’s GDP outpaces domestic economy’s GDP their stocks have a high potential to correlate with outperformance. Additionally, earnings in emerging markets remain strong. If you compare them to the S&P 500 earnings expectations (excluding the fiscal tax benefit) they are slightly higher. Combine these positives with the market price decline over the year, emerging markets are looking more and more attractive to add to a balanced and diversified equity allocation5.
What is continually in the eye of economists and investors alike is the flattening yield curve. We will continue to watch as the point of inversion gets closer and closer. While we believe an inverted yield curve (especially if held for more than a few months) has been a strong predictor of a recession looming, the timing of recession and the overall strength of the indicator this go-around may be “cause for a pause” in reacting too quickly. There are many indicators of the economy and we don’t look to just one to show us signs of a slowdown, but all indicators as a whole. As we see our economy move towards the later part in the cycle, we will look to make rational and objective decisions in changing our risk-exposure to all our managed portfolios.
A reminder, if you have missed any of our Month-In-Reviews you can find them archived on our website at https://www.aghwealth.com/p/month-in-review.
Thank you for your trust and confidence.
LPL Financial Advisor
Vice President, AGH Wealth Management
1 Morningstar Direct™
5 Weekly Market Commentary, LPL Research, May 21, 2018
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indexes are unmanaged and cannot be invested into directly. All indicies are unmanaged and may not be invested into directly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.