Stocks were strong in the second quarter. Investors pushed prices higher even as the economic environment became less encouraging. Two factors were primarily responsible for the bullish sentiment:
- The Federal Reserve raised the possibility that it might cut interest rates for the first time since December 2008.
- Anticipation rose that the US and China would reach a comprehensive agreement to end their differences on trade. (As of quarter-end, the situation remained unresolved.)
Large caps’ dominance persisted. Large caps outperformed mid and small caps for the fourth consecutive quarter, driven by superior first-quarter earnings results.
- The S&P 500 rose 4.3%.
- As represented by the Russell 2000 Index, small caps gained 2.1%. Combined with its strong first quarter, the R2K returned 17.0% in the first half of 2019.
- Growth outperformed value in all cap ranges.
Bonds rose on weakening economic growth and potential rate cuts. Bond prices benefited from concern that global economic growth was weakening.
- The 10-year Treasury yield closed at 2.00%, down 40 basis points during the quarter.
- The high-quality Bloomberg Barclays US Aggregate Bond Index gained 3.1% and outperformed the Bloomberg Barclays US Corporate High-Yield Bond Index, which rose 2.5%.
Equity gains lifted convertibles. As with stocks, convertibles of large cap companies dominated those of mid and small caps. Higher-delta issues outperformed higher-yielding alternatives. The Thomson Reuters All Cap Focus Convertible Index gained 1.0%, while the cap-weighted ICE BofAML All Convertibles, All Qualities Index climbed 3.9%.
Active management and security selection continued to drive performance across all strategies. After a solid first quarter of positive returns, all of our strategies continued to generate solid gains in the second quarter and first half. Positions in innovative technology and healthcare companies were the strongest contributors to absolute performance across all portfolios. (See page 3 of pdf for product and benchmark returns.)
Global growth is slowing. A variety of signs are pointing to decelerating global economic growth:
- GDP forecasts for a number of major nations are declining.
- PMI manufacturing activity—a crucial indicator of economic health—are stagnant or weak for most large economies. Results for June show that manufacturing is contracting widely, with few exceptions (notably France).
- Prospects for a US-China trade deal in 2019 remain uncertain, with no concrete progress to date. As time passes without a resolution, moreover, the stalemate’s negative effects are being felt in lower of activity.
Expectations for earnings and revenue growth are fading. According to FactSet, the consensus year-over-year growth rate for second-quarter S&P 500 earnings is -2.6%, down from -0.5% three months ago. The corresponding numbers for revenue growth have dropped as well: 3.8% now versus 4.5% earlier. While these figures clearly point to greater challenges ahead, they also suggest that investors will pay premiums for dynamic growth companies—which could present attractive opportunities for active managers.
Stocks are at or close to all-time highs. The S&P 500 hit new all-time highs in the second quarter and continues to do so as we write early in the third. That this is happening despite the substantial concerns we’ve cited suggests that stocks’ upward momentum may be due for a pause.
Small caps appear poised to do well. Even as small caps hit new highs, their valuations relative to large caps continue to trade well below the long-term average. Citi Research, in fact, notes that small caps are trading at their second-lowest level versus large caps in 10 years. As we see it, a technical breakout and mean reversion could drive small caps higher.
IPO activity is on the rise. FactSet reports that first-half US IPO proceeds hit $37 billion, more than half the $64.8 billion raised in all of 2018. Technology and healthcare companies account for nearly 50% of the total number of IPOs year to date—which expands the universe of opportunities in those sectors, provides greater potential for dispersion and thus raises the probability that active managers can outperform.
WHERE WE STAND NOW
Earnings and revenue growth is the key to performance. Active, disciplined stock selection—the foundation of our approach—should be a difference-maker in the current environment, in our view. Companies that can generate true secular, organic earnings and revenue growth (i.e., not dependent on GDP growth) are best positioned for success.
We thus continue to focus on dynamic companies whose disruptive innovation and differentiated business models can drive faster growth, as well as those whose businesses are domestically focused and less vulnerable to global economic weakness.
Favoring disruptive and innovative niches in healthcare, tech, and REITs:
- In healthcare, we are positioned in well-capitalized small- and mid-cap growth companies focused on curative therapies to address unmet medical needs. Since we expect ongoing market volatility as election rhetoric about drug pricing increases, we have no exposure to large cap biotech and pharma companies with both considerable non-US sales and large spreads between US and non-US pricing pressure.
- Our technology holdings emphasize subscription software providers whose consistent revenues lessen the risk of financial underperformance.
- REITs offer discrete opportunities to invest in accelerating direct-to-consumer e-commerce trends such as home delivery of fresh, high-quality foods and meals.
More mindful of credit and quality. Stock selection remains critical and, with greater risks to growth, credit and quality should become increasingly important to company-specific outlooks.
Taking prudent steps. At this stage in the cycle, we’re taking profits in companies whose growth catalysts are fully reflected in their valuations and moving away from companies that are more reliant on economic growth.
Disclosure: Nicholas Investment Partners, L.P. (“Nicholas”) is an independent investment adviser registered with the SEC. Registration with the SEC does not imply a certain level of skill or training. The firm maintains a complete list and description of performance composites, which is available upon request. Policies for valuing portfolios, calculating performance, and preparing presentations are available upon request. Past performance is no guarantee of future results. No part of this material may be copied or duplicated or distributed to any third party without written consent.
Nicholas does not guarantee the success of any investment product. There are risks associated with all investments and returns will vary over time due to many factors such as changing market conditions, liquidity, economic and other factors. The value of investments can go down as well as up, and a loss of principal may occur. Although Nicholas attempts to limit various risks, risk management does not imply low risk. All risk models are inherently limited and subject to changes in economic, political and market conditions, as well as changes in the strategies’ holdings, among other things, which could affect the risk profile of any portfolio managed by Nicholas. Small- and mid-cap companies may be subject to a higher-degree of risk than larger more established companies’ securities. The liquidity of the markets for these small and mid-cap companies may adversely affect the value of these investments. Concentrated or sector strategies are expected to maintain higher exposures to a limited number of securities or sectors which could increase the volatility, market, liquidity and other risks of the strategy.
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