Royce Funds Commentary: Tariffs, Pullbacks and Fundamentals

The roughly four-month rally that brought the equity markets out of their late 2018 downturn met its first challenge in May, when stocks across much of the globe stumbled through the month with negative returns. Much of this correction resulted from yet another spate of trade and tariff trouble, including the ongoing dispute between the U.S. and China as well as the unpleasant surprise of proposed U.S. tariffs on Mexico, a situation that was quickly resolved.

The pace of global growth also continued to slacken in May as global PMIs fell, while in the U.S., this weakness, combined with anticipated slowing from tariffs, was reflected in reports of sizable negative revisions to earnings estimates for the second quarter.

Additional data added weight to more fatalistic points of view. The yield curve began to invert in March, leading to renewed pessimism about the state of global growth and related worries about the possibility of imminent recession in light of the inverted curve’s historical role as a predictor of economic contraction. The most recent U.S. jobs reports from 6/7/19 showed a relatively paltry 75,000 jobs added for May, far less than the anticipated 185,000.

• SPY 30-Year Financial Data
• The intrinsic value of SPY
• Peter Lynch Chart of SPY

Of course, the events that matter most are typically those that no one sees coming—and it’s important to remember that this holds true for good news as well as bad.

Equally important, especially with investors having more than enough challenging news to complicate their investment decisions these days, is the fact that the current news is not all bad.

For example, the U.S. economy continues to chug along in the midst of global weakness, with recent domestic PMIs that show slower growth that is still, nonetheless, in solidly expansive territory. Housing starts rose in April—and with mortgage rates remaining low, the sector looks likely to be a domestic bright spot through the end of the year.

The significant service sector of the U.S. economy—its share of economic activity is four times that of manufacturing—continues to gain strength. Perhaps most notable was the market’s positive response to the underwhelming May jobs report. Many investors seemed convinced that this most recent sign of an economic slowdown would compel the Fed to lower rates. And it is true that the developed world’s central banks have been sending accommodative signals of late.

We choose not to capitulate to the negative view or adopt a blindly optimistic one. It’s seems clear to us that there is an odd mix of discouraging data with ongoing positive trends.

To us, the current unwieldy mixture suggests the unlikelihood of recession in the near or intermediate term. With yields falling and prices climbing, equities continue to look more attractive than bonds, though we suspect that stocks should see increased volatility in the months ahead as investors try to sort out where companies are headed.

As highly active, bottom-up small-cap specialists, we pay the closest attention to our own company research and meetings with management teams. Here, the news remains constructive. While admittedly anxious about the uncertain pace of global growth, the managements of most of our holdings are generally confident in the condition of their respective order books.

Reports of revisions notwithstanding, earnings prospects for the second half of 2019 look solid for many of our small-caps—in some cases, even more promising given the relatively weaker third and fourth quarters of 2018 with which 2019’s two second-half quarters will be compared.

And while it’s true that many small-caps in the cyclical sectors that we lean toward have been hurt most in the current pullback, it’s also true that many of these same companies are trading at much lower valuations than defensives relative to each category’s long-term averages.

As the state of growth continues to be harder and harder to gauge, we believe that fundamentals are likely to matter more and more. The cloudier macro picture may lead investors to incline toward companies with sustainable business models, high returns on invested capital, positive cash flows, and/or the potential for earnings strength and profitability—among the primary sweet spots for risk-aware active management approaches.

Stay tuned…

Important Disclosure Information

Mr. Gannon’s thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce & Associates, LP, and, of course, there can be no assurances with respect to future small-cap market performance.

Cyclical and Defensive are defined as follows: Cyclical: Consumer Discretionary, Energy, Financials, Industrials, Information Technology, Materials. Defensive: Consumer Staples, Health Care, Real Estate, Telecommunication Services, Utilities.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

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