US small caps falter as reflation trade falters

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NEW YORK: Expectations of a slowing US economic recovery in the second half of the year weigh on small-cap stocks, forcing fund managers to look for companies that could continue to profit in a lower growth environment.

The Russell 2000 Index, which tracks small businesses, has underperformed the S&P 500 in each of the past four months. Investors withdrew nearly $ 108 million from the iShares Russell 2000 exchange-traded index fund in the week ending July 14, the third consecutive week of cash outflows totaling nearly $ 965 million and represent the longest streak of losses for the ETF since April.

Small-cap stocks have been among the beneficiaries of so-called reflation trading, which has also seen investors bet on stocks of banks, energy companies and other economically sensitive companies and reduce their positions in US Treasuries in anticipation of a strong economic rebound. The Russell 2000 is up 11.6% this year, compared to 16.3% for the S&P 500.

Some now believe that the rebound has run its course and that the economy will slow down in the coming months, triggering a rotation into high-growth and tech stocks that have driven markets higher over the past decade.

Yields on the benchmark 10-year Treasury index, which move in the opposite direction to prices, edged up on Friday but remained close to their lowest levels since February. In testimony to Congress earlier this week, Federal Reserve Chairman Jerome Powell said the rise in inflation would likely be transient and the US central bank would continue to support the economy, adding to pressure on yields.

“We may have passed the peak of inflation fears, and we are also past the peak of optimism for growth,” said Brian Jacobsen, senior investment strategist at Wells Fargo Asset Management.

His company has reduced its overweighting in small caps and is now neutral on the asset class due to expectations that the economic boom from the coronavirus recovery will be short-lived.

Overall, fund managers unwound their bullish bets on small caps versus large caps to return to levels last seen in October 2020, before the announcement of effective coronavirus vaccines helped fueling a disproportionate rally in cyclical and small-cap stocks, according to a global survey of fund managers by BofA Research.

Low bond yields are likely to continue to weigh on small caps, as investors opt for income sources such as dividend-paying stocks rather than seeking capital gains, said Lamar Villere, portfolio manager at Villere & Co.

“People are trying to pursue all the returns they can and it comes at the expense of small caps. You have this huge demand on the client side for blue chip dividend paying stocks right now because that’s the only place where you can get any kind of return, ”he said.

His company has not added any new small-cap positions in the past six months, he said, and has instead added companies such as media giant Viacom Inc to its portfolios.

Investors will get additional clues as to the extent of the expansion of the US economy over the coming week from data showing new housing starts on Tuesday and an index of key economic indicators on Thursday.

Netflix and Twitter, meanwhile, are also expected to release their latest quarterly results in the coming week, giving investors a deeper read on how the reopening of the economy has affected income growth.

Signs that high inflation will persist longer than the Fed expects could support small caps, said Jim Paulsen, chief investment strategist at Leuthold Group.

Overall, the Russell 2000 is expected to post 50% earnings growth in fiscal 2021, compared to 44% earnings growth for the large-cap S&P 500, according to Jefferies.

This outsized growth rate and the high valuations of the S&P 500 could make small caps play against the grain for the rest of the year, said Saira Malik, chief investment officer for global equities at Nuveen, who said that it had added to financial data in hopes that the 10-year Treasury yield will end the year close to 2%.

“We really think it will be more difficult in the second half, but there will be some permanence to inflation and that would be positive for small caps,” she said. – Reuters


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