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RETAIL REPORT: Navigating The Wall of Worry with Small Caps

Traders Magazine Online News, October 30, 2018

Eric McLaughlin

US small-cap stocks lost their lead over blue chips in early October’s sell-off, which was likely prompted by fears of higher interest rates. We believe such fears were unjustified and that the sell-off was a correction in a bull market.

The environment for investors in US equity continues to be skewed towards the positive. Recent US economic reports have been encouraging: real gross domestic product (GDP) increased by 4.2% in the second quarter of 2018, according to the second estimate by the Bureau of Economic Analysis. In addition, the ISM Manufacturing Survey is reporting a reading showing robust expansion and the latest jobs report was strong, with the unemployment rate at the lowest level since 1969.

Meanwhile, the third quarter earnings season has begun well extending the run of strong realised earnings growth seen so far this year along with healthy expectations for future growth.

The continued strength of the US economy, partially driven by tax cuts and fiscal spending, meant that investor and business confidence has remained robust.

Shifting expectations for monetary policy made themselves felt

At a press briefing in mid-September Chairman Powell was extraordinarily positive on the economic outlook. In addition he recently commented that the stance of monetary policy remains “a long way from neutral” and may ultimately need to move into restrictive territory.

While these comments should not have been a surprise to investors (they are aligned with the FOMC’s economic and interest rate projections), they do represent a change in thrust from Chairman Powell who had previously focused only on the need to normalize policy gradually over time, staying away from sharing his own view on whether policy would eventually turn restrictive.

These comments from Chairman Powell likely contributed to higher anticipated policy rates and the rise in Treasury yields.

Small caps have had a strong run…

During the six months through August 2018 small caps outperformed large caps for five of the months. This corresponds to the period from March when the possibility of a trade war began to gain attention. Small caps’ outperformance over large caps since February is the strongest since the global financial crisis (+15.6% vs + 7.6%). In our view the idea that small-cap stocks represented a relatively safe bet under this scenario was justified. The level of outperformance left small caps due a correction versus large caps (see Exhibit 1 below).

Exhibit 1: Having outperformed in 2018 year-to-date through August small caps underperformed large caps in the recent correction


Source: Datastream, BNPP AM au 17/10/2018

Early October was a correction, not the start of a bear market

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