The S&P 500 has been making headlines this summer, posting its longest ever bull market despite growing volatility elsewhere in the world. Indeed, it remains on course to beat other developed-market equity indices by more than 5% for the second successive quarter. However, it is US small caps that have attracted our attention.
While on the face of it, investors have been reducing their equity exposure in favour of fixed income, we would argue that portfolio risk may not have come down significantly as investors remain heavily invested in riskier types of equity, with a small overweight to small caps and non-US equities.
The greater appetite for small companies has been reflected in recent performance, particularly relative to their larger US peers, with the S&P 600 and Russell 2000 outperforming the S&P 500 both this year and since President Trump’s election in 2016.
We think there has been a sound basis for this outperformance. Factors that have supported small caps include the passing of the Tax Cuts and Jobs Act last December, as well as strong US growth and emerging market volatility which has led investors to rotate into riskier domestic assets. The dollar has been another recent contributor to the relative performance of small and large companies, with the US Dollar Index (DXY) appreciating by up to 8% since April this year. In the short term a stronger dollar should benefit small caps as they derive much larger shares of their revenue from the domestic market than the S&P 500 and their earnings are thus less sensitive to currency moves.
However, we see growing risks that small caps may face some headwinds. For one, the US dollar might not continue to support smaller companies as it has over the past few months. If the Fed delivers a rate hike per quarter until 2020, per our expectations, the extra financing costs from higher rates will probably offset any short-term relative gain even if the dollar does appreciate. In the long run, the downsides of the ongoing trade war with China could also have a more negative impact on smaller companies, as they have less flexibility to absorb shocks to their costs and revenues from the impacts of tariffs.
More tangibly, we think that small-cap stocks may be approaching the end of their strong relative outperformance as this performance has become increasingly extreme. When compared to their long-run trend, the relative returns of small caps reached nearly two standard deviations above their trend in August. Such an extreme level has been a reliable signal of a peak in the outperformance of small caps since 2001. The chart below also highlights a strong correlation between the relative performance of small-cap stocks and that of cyclical versus non-cyclical sectors, as both are sensitive to fluctuations in the macroeconomic cycle. Cyclicals have underperformed defensives since mid-June.
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