Three overlooked facts that investors ought to consider

Uncovering three facts investors ought to be aware of

The recent hot inflation data has made it seem like the Federal Reserve will hold off on the anticipated rate cuts longer, and the chaos in the geopolitical scene has got investors uneasy.

Despite this, there is a bright side to it – the US economy remains strong, and it seems the Fed has reached its peak with raising interest rates.

The question now is: how does an investor weigh these pros and cons?

Michael Arone, Chief Investment Strategist at State Street's SPDR, talked to Before the Bell about three things about the market right now that people might not be aware of.

It might be of surprise to many that small- and mid-cap stocks have shown better performance than large-cap stocks in recent times.
The "Magnificent 7," which is Amazon, Tesla, Alphabet, Meta, Apple, Microsoft, and Nvidia, haven't been as dominant this year as before.
For the first time, long-duration US Treasuries have experienced negative returns.

The interview has been edited for clarity and length.

Do you think it's surprising that small- and mid-cap stocks have outperformed large-cap stocks over the past few months? And what does that tell us about the markets?

A lot of people believe the S&P 500 has been outdoing everything else due to the influence of the Magnificent 7. In reality, though, since the S&P 500 reached a low in October, it's been mid-cap and small-cap stocks that have been outperforming. This was a result of Treasury making the decision to issue Treasury bills instead of bonds with longer interest rates, which led the rates to drop and the Fed considering cutting them as well. The beneficiaries here, which is the mid-cap and small-cap stocks, would be a pleasant surprise for most investors.

However, with the expectations of fewer rate cuts now, the S&P 500 has overtaken these stocks in terms of performance. However, I'm convinced that the Fed will make rate cuts later in the year, and as this happens, the trend of mid-cap and small-cap stocks outperforming large caps should revert.

What's your take on how the market concentration and the Magnificent 7 are a myth right now?

While the S&P 500 is heavily influenced by the biggest stocks, the real surprise is that industries such as industrials, financials, and energy have done well this year instead of technology. The Communication Services sector has fared well, but not necessarily in a way that pins everything on the Magnificent 7. When we look at other indexes such as the EuroStoxx 50 and some Japanese equities, they've performed just as well if not better than the S&P 500.

I don't think the scenario in the US is representative of the global market. Even though owning the S&P 500 makes one depend a lot on the Magnificent 7 for risk and returns, a diversified portfolio of various other investments has better returns. Other areas like gold, for instance, have also performed well.

It's significant that long-duration Treasuries have delivered negative performance since July. Can you expand on this?

The traditional pattern is for the Fed to raise rates, which slow down the economy and cool down inflation, followed by lowering rates. However, this time things have changed, and rates aren't falling but rising instead.

The yields are made up of growth expectations, inflation expectations, and a factor called the "term premium." Normally, growth hasn't been as good as the market expected, inflation hasn't matched up with expectations, and the Treasury is buying less than historically with their large deficit. This makes for more supply and less demand, leading to higher rates. The fact that it's never happened like this before makes it an unexpected turn in the market.

The Federal Reserve made an announcement last week that it will be winding down its quantitative tightening program. This has sparked some speculation on whether or not this will have any significant impact.

10-year treasury yields have seen a slight decrease today. This is a result of Fed Chair Jerome Powell stating that they do not anticipate any further rate hikes. Rather, the focus has shifted towards rate cuts, but when will this occur?

The current economic climate is cooling off, with the latest GDP figure indicating that growth is slower in the US economy. This downturn in growth could potentially lead to a decline in yields. If the Fed adjusts its monetary policy accordingly, this could also aid in the process. However, there's still the issue of persistent inflation. While it's true that certain supply-demand imbalances and factors like the housing market, labor market, and energy prices are contributing to this, it's important to note that they may keep rates elevated.

Sticky inflation is a complex problem with various factors at play, such as supply-demand imbalances, the transition from fossil fuels, geopolitical conflicts increasing oil prices, and large government deficits. These aspects could keep rates higher than the market anticipates. That doesn't necessarily mean that rates will continue to rise, but rather that the market is expecting a more substantial drop than what may actually transpire.

In completely unrelated news, Berkshire Hathaway welcomed tens of thousands of shareholders and fans to Nebraska this past weekend. This year's event was unique in that it marked the first time Warren Buffett appeared without his longtime business partner and friend, Charlie Munger, who passed away in November. Greg Abel, the potential successor to Buffett who manages Berkshire's noninsurance operations, and Ajit Jain, who runs the insurance business, joined Buffett on stage. Despite their absence, Buffett still released his quarterly report as usual. Berkshire's operating profits per Class A share rose to $8,825, while the Class A stock has grown by nearly 10% this year, outperforming the S&P 500 which gained 7.5%.

However, Berkshire's net profit in the first quarter was significantly lower than the previous year's, amounting to $12.7 billion instead of $35.5 billion.

In more retail news, it seems that stores are starting to feel the pressure from cautious shoppers. To encourage spending, many retailers are reducing prices drastically on various products. This is especially evident in categories considered to be discretionary purchases, like home decor and arts and crafts. Ikea, for example, has slashed prices on numerous items: an 18-piece dinnerware set is now $29.99 instead of $49.99, a glass door bookcase is $189 instead of $229, and a bedframe with storage and headboard is $499 instead of $549. This could suggest that consumers are choosing to prioritize needs over wants.

We're seeing retailers capitulate to consumer concerns after two years of relentless inflation squeezing pockets and forcing Americans to make hard decisions. This is not only a concern for retailers and consumers, but also for the entire American economy, which relies on the majority of its revenue from consumer spending. Apparently, stores are the ones that seem to be backing down first by cutting prices on many products.

Many big retail chains are undertaking planned discounts this month, aiming to win back consumers. Bed Bath & Beyond, which filed for bankruptcy in November 2020, recently offered a 35% discount on a range of home items. During Bed Bath & Beyond's last quarter, its revenue declined by 20%. Similarly, Ross Stores, an off-price retailer, slashed prices by 50% on many products earlier this year to lure customers.

Michael Burke, senior partner and portfolio manager at LA Capital, observes that retailers have been facing pressure, and many have resorted to this tactic to stand out among their competition. He notes that these discounts could help attract more customers, but it's uncertain whether they'll experience a lasting rebound from the trends that preceded the pandemic.

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In light of the market analysis, some investors might consider diversifying their business portfolios beyond large-cap stocks to include mid-cap and small-cap stocks, given their recent performance.

Given the current market circumstances with the Fed holding off on rate cuts and the outperformance of mid-cap and small-cap stocks, it could be a strategic move for businesses to invest in these sectors.

Source: edition.cnn.com