All Cap Value – Q2 2018 Commentary
For the first half of 2018, global equity markets have experienced increased volatility and uneven performance after a strong and very smooth increase for 2017. The increased volatility for 2018 has stemmed from fears of higher interest rates tied to increased inflation expectations, trade wars initiated by President Trump and concerns about the sustainability of a synchronized global economic expansion. Collectively, stock price appreciation globally added $9.6 trillion of value during 2017 or a 22% increase for the S&P Global Broad Market Index (S&P BMI) which includes total stock performance tracked for 48 countries. For the first half of 2018 the S&P BMI index is down 1.3%. U.S. equities, however, have collectively bucked the negative global trend. For the first half of 2018, large technology and small cap U.S. stocks exhibited solid performance with the technology laden NASDAQ index +6.61% for Q2 and +9.37% ytd and the small cap Russell 2000® index +7.75% for Q2 and +7.66% ytd. Both groups are perceived to be less sensitive to trade wars and better exposed to the strong U.S. economy which is benefitting from tax cut stimulus and full employment. The trade wars, which started to ramp in late May when President Trump imposed Steel and Aluminum tariffs on imports, has hurt international and emerging market indexes along with U.S. stocks exposed to global trade and higher interest rates. For instance, the Dow Jones Industrial Average®, with its large exposure to industrial and interest rate sensitive stocks has been held back with a small increase of 0.7% for Q2 and a decline of 1.8% for the year.
For the most part, the U.S. and Global economies continue to be in good shape with the IMF recently increasing global GDP growth prospects by 20bps from 3.7% growth in 2017 to 3.9% growth for 2018 and 2019 on U.S. tax cuts, favorable global financial conditions and improving demand.
Operating earnings in the US are expected to grow greater than 20% for 2018 as companies benefit from lower taxes, improving revenues and improving global economic expansion. The strength in EPS growth has also lowered the P/E ratio of the S&P 500® from 20.52x last year to 17.48x this year.
The strong economic growth is being tempered by fears of inflation and protectionism. The markets have been fairly sanguine regarding inflation risk. Even with the tight labor markets, increased trade protections and higher commodity/oil prices, Inflation has hovered around the Federal Reserve’s target of 2% with the recent May Personal Consumption Expenditures (PCE) index, ticking up to 2.3%. The Federal Reserve has methodically raised its Federal Funds rate by 0.25% increments from 0% to 1.5% over the last 18 months and is expected to increase 2 more times or 0.5% by the end of 2018 as it tries to normalize it’s benchmark rate. The bond market, however, appears to be pricing in slower growth and more subdued inflation. The disconnect between the Federal Reserve and market-driven, longer term interest rates is resulting in a flatter, yet still upward sloping yield curve. The flatter yield curve is indicating slower growth and lower inflation. If inflation readings continue to be benign, we would expect the Federal Reserve to begin to curtail its tightening policy and refrain from choking off the economic expansion. On the protectionism front, there has been a lot of talk but still very limited new trade barriers. Hopefully this continues to be a lot of bluster with little substance.
Ending the second quarter of 2018, All Cap Value increased 1.11% (gross of fees) and 0.94% (net of fees) vs. 1.71% for its benchmark, the Russell 3000® Value. For the year, the All Cap Value 2
Composite is down -1.79% (gross of fees) and -2.12% (net of fees) vs the Russell 3000® Value’s decline of- 1.16%. Health Care and Utilities posted positive relative performance for the second quarter and first half of the year and helped offset weakness in Financials and Energy.
Overall, it appears that economic growth continues to improve at a sustainable pace with little inflation over the near term which should create a positive environment for equites. Some of the recent selloff in certain sectors is allowing our sector specialists to find good companies with positive returns on capital trading at decent valuations.
As always, we want to thank you for the confidence you have placed in Kennedy Capital Management.
Frank Latuda, Jr. CFA®
Chief Investment Officer & Portfolio Manager
Thomas Leritz, CFA®
Assistant Portfolio Manager