Trade Idea: Equity US Small Caps To Outperform

US Economy to Exhibit Robust Growth: – We believe that the US economy is in a fundamentally strong position. Temporary factors, such as bad weather and labour disputes, caused the economy to shrink in the first quarter; however more recent data points to a return to robust growth…

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Falling unemployment, stabilising inflation and good manufacturing data all highlight the strength of the underlying domestic economy.

– In the coming year we expect to see the US economic recovery support corporate earnings and sustain the healthy equity market performance that we have seen year to date. A potential headwind comes in the form of a stronger US Dollar which may reduce the competitiveness of large corporations with international operations. The current environment is favourable for US small caps which, due to their size, provide a direct exposure to the domestic economy while limiting exposure to adverse currency movements.

Small Caps Outperform Large Caps

– Over the past five years, the Russell 2000® Index has outperformed the S&P 500 Index by 11.6%, and on an annual basis performed better in three out of the five years.

Impact of the Rate Hike

– The primary concern surrounding an allocation to small caps in the current environment is the impact of the upcoming interest rate hike on returns. As small caps require greater external financing than their large cap counterparts, it would be logical to assume that a rate hike would increase the cost of capital and in turn harm stock valuations. However, looking historically, rising interest rate environments tend to coincide with favourable economic conditions. Indeed, in the latest two tightening cycles (Oct 1998-Jul 2000 & Jun 2004-Jun 2006) the Russell 2000® Index outperformed the S&P 500 Index.

– The US Federal Reserve Chair, Janet Yellen has also stated clearly to markets that any tightening would be gradual in nature, which should reassure investors that the impact of upcoming interest rate hikes on small cap returns should not be overly dramatic.


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