Key Takeaways
- The climb in market-beating US small caps will continue as valuations look cheap versus large caps, says Morningstar Wealth’s Pappalardo.
- Latin American shares, particularly in Brazil, are expected to shine, owing to energy exports.
- Pappalardo says to steer clear of US credit in favor of developed market sovereign bonds.
Amid a volatile year, both small-cap and Latin American stocks have been rallying since the start of the Iran war at the end of February. Morningstar Wealth chief multi-asset strategist Dominic Pappalardo and his team predict that these stocks will continue their run throughout the year. At the same time, his team remains skeptical of US large-cap stocks and US corporate credit, believing they look overvalued.
This year’s stock market winners and losers will be marked by concerns of runaway inflation, knock-on effects from the war, and worries about the possibility of an AI bubble, Pappalardo explains. Those factors, geopolitical uncertainty, and the midterms “are most likely to have major impacts on market movements for the rest of the year,” he says. And instead of US corporate credit, his team believes developed market sovereign bonds can supply the needed yield.
The Case for Small-Cap Stocks
So far this year, the Morningstar US Small Cap Market Index is up 14.0%, versus 10.7% for the Morningstar US Market. Small caps are Morningstar Wealth’s largest overweight position in its US equity portfolios. The Morningstar US Equity Fund MSTQX, which Pappalardo’s group manages, has 10.2% in small caps, well overweight compared with just 4.2% for the large blend category.
Through June 30, small-cap stocks are roughly 6 percentage points ahead of their large-cap counterparts, as measured by their Morningstar indexes. They’re also 3.3 percentage points ahead of the broader US stock market.
“The quiet surge in small caps has momentum to continue,” Pappalardo says. US small-cap equities have underperformed their large- and mid-cap peers over the past 15 years. He says the group is more diversified than large caps: “40% of the S&P 500 is made up of the top 10 names, and nine of those are tech or tech-related.”
At the same time, the 10 largest small caps account for a much smaller percentage of the small-cap indexes. Plus, on a relative basis, small-cap stocks are looking more undervalued than they have in a long time, as the Morningstar Wealth team thinks large caps look overvalued.
Out of US Corporate Credit, Into Developed-Market Sovereign Debt
Coming into the year, Morningstar Wealth was overweight in small-cap and non-US stocks, and “we were pretty conservative on the fixed-income side on credit,” says Pappalardo. The turn toward overseas equities “was a function of the market’s valuation.”
The group was skeptical about corporate credit because spreads remain historically tight. “Credit fundamentals are fine, and are actually pretty strong, but we just don’t believe you’re getting paid for the additional credit risk,” he says. Instead, the team substituted developed-market sovereign bonds for credit exposure in client accounts, using Vanguard Total International Bond Index Fund ETF Shares BNDX.
“Obviously, the disadvantage of being underweight credit is you give up yield and income,” Pappalardo says. “You can buy a broad basket of developed market global government bonds and pick up yield over and above US Treasuries. Countries like Japan, the UK, and France are in that group.”
Latin American Stocks Are Poised to Rise on High Oil Prices
Pappalardo says a bullish investment thesis for Latin American equities “really surfaced” in March, after the Iran war began. As is usually the case in a risk-off environment, emerging markets initially lagged developed ones. But Latin America includes energy exporters like Brazil (the region’s largest crude oil producer and a major global exporter), as well as Mexico, Colombia, Venezuela, Ecuador, Argentina, Trinidad and Tobago, Peru, and Bolivia.
“Valuations were becoming more compelling as prices dropped, but those same countries were actually benefiting from an economic tailwind as their main export, [oil], was going up in price. That was really the catalyst to increase that emerging markets exposure.” For client accounts, they added iShares Latin America 40 ETF ILF. While the valuation differential has narrowed, Pappalardo still likes Brazil.
But elsewhere in emerging markets, he’s shying away from South Korea and Taiwan, which rallied sharply this year. He’s still hanging onto China. For clients, the team uses iShares MSCI China ETF MCHI and the broader emerging markets portfolio of Vanguard FTSE Emerging Markets Index Fund ETF Shares VWO.
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