Time to be Small

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Equity markets recovered some of their mojo last week. Global equities gained 2.0%-2.5% in sterling and local currency terms respectively and are now only 0.5%-1.0% below their mid-February peak.

In the US, a number of equity indices have touched new all-time highs in recent days. The S&P 500, which is the benchmark generally used by professional investors and measures the performance of the largest 500 stocks, inched above its previous peak. The Dow Jones Industrial Average, by contrast, which generally dominates the headlines but is a very narrow and flawed index of 30 cyclical stocks, easily surpassed its high earlier in the month.

But it is small cap stocks in the US, which have really been on a roll of late, returning 19% this year versus 5% for the S&P 500. This burst of outperformance follows years of being trounced by large cap stocks which have benefited from the surge in the tech titans. The reason for the change in fortune is the prospect of a sharp rebound in the economy over coming months which will benefit the minnows much more than the behemoths.

Growth forecasts for the US have been revised up significantly in recent weeks. Not only has the vaccination roll-out gathered pace but President Biden last week signed into law his massive new $1.9trn fiscal stimulus package. This amounts to 8.4% of GDP, with the most eye-catching element being the $1400 cheque most individuals will now receive. Some of this hand-out will be spent while some no doubt will end up in the stock market.

Small cap stocks have also been on a roll in the UK, returning 15% year-to-date versus 6% for the FTSE 100. Here again, the hope is for a strong economic rebound though this time it is based much more on the rapid vaccine roll-out, with Chancellor Sunak rather less generous in his hand-outs than President Biden.

Much of the outperformance of small and mid cap stocks in the UK, and to a lesser extent the US, is now probably behind us. Even so they should continue to benefit from favourable tailwinds for a few months yet and we plan to retain our tilt to these areas for the time being.

Equities have managed to resume their upward path even though government bond yields rose further last week. Strong growth and a marked rise in inflation will very likely continue to drive yields higher over coming months but we believe this shouldn’t prevent equities seeing further gains.

Importantly, the rise in yields is being driven in large part by growth forecasts being revised higher which is good news for corporate earnings and equities. Moreover, even after these increases, yields will still remain at historically low levels with central banks doing their best to contain the rise.

The Fed has been at pains to emphasise that it will be very cautious in scaling back its QE program and is still a long way from raising rates. At its meeting this Wednesday, it will be updating its economic forecasts following the Biden stimulus and these will be scrutinised closely for any clues as to any change in its thinking.

The European Central Bank has taken rather more overt action to stem the rise in bond yields, pledging last week to step up the pace of its bond purchases. With the vaccine roll-out in the EU proceeding much slower than in the UK and US, a new wave of infections seemingly underway in some countries such as Italy, and a considerably smaller fiscal stimulus than in the US, the ECB is under pressure to do what it can to support the recovery.

Here in the UK, the lockdown-related decline in GDP in January was a smaller than expected 2.9%. This good news, however, was tempered by a collapse in EU trade in the same month with exports down as much as 40%. Only time will tell how much of this Brexit-related decline just reflects teething problems and earlier stockpiling, rather than new longer lasting impediments to trading with the EU.

The Bank of England also meets this week on Thursday. But with no change in policy in the offing and no new forecasts to pore over, the market’s attention even more so than usual will be focused firmly on the deliberations of the Fed rather than the MPC.

Rupert Thompson

Chief Investment Officer