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Small Caps deal with rising rates

The Days Ahead: Fed minutes but otherwise a quiet week.

One Minute Summary There is one stock index at a record high. Take a bow, U.S. Small Cap stocks, which are up 6% this year and climbed over their January 24th record high. We actually prefer the S&P 600 as a small cap index, for reasons we explained here.  That has also hit an all-time high and is up 7%, mostly because it excludes speculative, blowout companies that don't make money. Why the small cap love-in? Well, put most of it down to recent dollar strength. Small companies don't have the same overseas exposure of the S&P 500 large cap so are less affected by a strong dollar.

Stocks had a sideways week. We kind of expected that because economic news has been fair to middling and the trade stuff is very much in the background. Total containers moving from the Port of Long Beach jumped 16% in April. We think that’s down to exporters and importers trying to get ahead of the announced trade restrictions from March 1.

Housing, retail sales and industrial production all came out. They were steady, not spectacular. We think we've reached the peak in housing for this cycle. It’s at 1.26m compared to the pre-recession record of over 2m. Higher mortgage rates will keep housing demand flat for a while.

European markets struggled mostly with the news from Italy. Italian stocks had been one of the best performers but investors sent bond yields up by 40bp in less than two weeks. It’s all down to politics. U.S. bond yield also climbed. The economic news seems to confirm the Fed outlook. Steady growth and interest rate hikes.

1.     How are the tax cuts going?  Well, one area you’d expect to thunder ahead would be retail sales. Lower taxes, more take-home pay, more discretionary income, stable inflation, more confidence. Personal consumption is 68% of the $19.9 trillion U.S. economy. Knock out some essentials like food, housing and health care and there is around $7.5 trillion of spending. We were waiting for the April numbers because the tax refunds were done, the new withholding sorted and the distortions caused by the hurricanes (where people bought forward purchases of furnishings and autos) were over.

Surely the new confidence was at hand? Last month’s retail sales (blue column) were up 4.6% YOY, which was down on the prior month but marginally better than the start of the year. We also took a look at what people spend on necessities.

That number was also up 4.6%. What stood out was the 12% increase in spending at gasoline stores (the lower chart). Now, we know, not all sales at gasoline stores are of gasoline but neither are they big-ticket sales reflecting solid confidence. Our read is that basic household items absorb much of the increase and that discretionary spending remains weak.

We're in the minority in thinking these retail sales were pretty meager. The Atlanta GDP Now model raised its estimates for Q2 growth and the 10-Year Treasury bond yield rose 8bp to 3.08%. We're going with around 3% GDP in Q2, less than most. But there is still half the quarter to go.

2.     Does the run up in bond yields change our outlook? No. We fully expected three hikes from the Fed this year. It may even be four. So, two or three to go. Our view on rates is built on inflation, growth and credit demand.

We also look at simple break-evens that measure how much yields would have to rise in a year to lead to an annual return of zero. Low yield and high duration numbers (which we had in January) mean lower break-evens and vice versa. An example is the current on-the-run (i.e most recently issued) 10-Year Treasury, which has a yield to maturity of 3.01% and duration of 8.41 years. The break-even is 3.01/8.41 = 36bp. So the 10-Year note yield would have to rise to 3.37% for the bond to return zero over the next 12 months.

The shorter the maturity the lower the duration. So a 2-Year Treasury yielding 2.55% with a 1.9 year duration has a break-even of 134bps. At the other end, a 30-Year Treasury at 3.13% and 19.19 years is only 16bp.

There’s always a risk of continued curve flattening (where there is not much difference between 2-Year and 10-Year rates) as this shows.

In an expanding economy the difference between a two and 10-year rate is more like 200bp, not the 49bp we see now. A flattening yield curve would mean long term bonds don't change much as front-end yields rise.

So what? Well this all means that we prefer the short to medium end of the curve, at the 7-10 year maturity or six-year duration. The break-evens are higher and the risk/reward looks attractive.  And that’s where we've positioned most of our bond portfolio.

3.     Women in the workforce. We talk a lot around here about demographics and the economy. One sure thing about demography is that you kind of know what’s going to happen. Today’s twenty somethings will, in 20 years a) still be alive and b) buying life insurance, savings products and sensible stuff. It gives you some idea of the overall direction of the economy. But one data item that really strikes us is this:

The top section shows labor force participation by sex in the U.S. The female work force has declined pretty drastically since the recession after years of climbing up. Japan is on the lower chart. That upward slope on women working is impressive. Japan has a real demographic problem. Its population has declined and the average age has crept up. Nearly 30% of the population is over 65. The government has put a lot of effort into attracting women into the workforce. And it’s working. We like where Japan is going for a number of investment reasons and this week’s slip in GDP does not overly concern us. The increase of labor participation seems a very good forward indicator.

Bottom Line: We'll be looking at news from Europe. Growth has stalled but we think it’s temporary. Next week will tell us more.

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--Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.