The small cap shift

Welcome to the August edition of Inview: Monthly Global House View. In this publication we consider significant developments in the world’s markets, and discuss our key convictions and themes for the coming months.

The rally in equity markets that characterized stock markets in the first half of the year, continued last month. The MSCI World index saw a gain of 1.8% in July, to bring year-to-date returns to 13.7%. However, the highlight of the month was the strong outperformance of US smallcap stocks, with the Russell 2000 index up by 10.2% in July, offsetting the sell-off in technology stocks.

Softer than expected June US CPI inflation data catalysed a change in investor sentiment that cemented expectations of a 25bps reduction in the fed funds rate at the Federal Open Market Committee meeting in September. This led to a shift in investor positioning away from mega-cap technology stocks into small-cap stocks. Smaller firms are more sensitive to interest rates given their greater dependence on external financing for growth than large-cap firms. Therefore, the potential for lower interest rates in the coming months triggered a rally in the sector. The broadening of market returns has been a positive for equities, particularly for US stocks.

A weakening in US economic data over the last month, predominantly declining manufacturing activity and a deceleration in the housing market, explains why bond markets rallied in July. The 10-year US Treasury yield fell by over 35bps over the month while both investment grade and high yield bond indices also rallied. However, we remain defensive on credit as bond spreads remain tight.

A small overweight to equities remains advisable for balanced mandates although we have reduced our exposure to equities as we move into the summer months, adding to high quality fixed income, with a small overweight in duration, as a means of managing portfolio risks.

Asset Allocation

Global Allocation

Following the reduction in equity exposure the previous month, we retain our modest overweight position. Given the recent outperformance of US small caps and a broadening out of market participation we think this sets a positive scene for the coming 2-3 months and so do not yet want to cut equity risk further. Economic surprise indices have turned negative for G10 economies and are in decline for emerging markets, so it has been unsurprising as to why the bond market has rallied lately. Expectations for a rate cut from the Federal Reserve in September have firmed and we have maintained our fixed income overweight. Alternatives positioning is still underweight, as is cash but are on the look-out for any opportunities in late Q3/Q4 to deploy cash. We remain alert to the possibility of enhanced market volatility over the summer months.

Fixed Income

The key risk to our core scenario in this context is the Fed not cutting rates in the coming months. If markets feel the Fed is too slow to start easing monetary policy and the economy slows faster than consensus, then the long end of the curve could rally significantly. Therefore, it is important to maintain duration higher than the benchmark for the time being. On allocation we remain defensive, not chasing the credit rally. Spreads remain tight despite the recent correction, which gives an indication that this is a profit-taking situation rather than a sharp deceleration and so we remain underweight in high yield. Rates are our favoured area of fixed income, alongside convertible bonds, in which performance has picked up recently due to the small cap equity outperformance.

Equities

US equity allocation overall remains underweight versus the benchmark where valuations remain relatively stretched. Following July’s rally in US small caps we are waiting on market dips to present buying opportunities. For now, we continue to have a small overweight position in European equities while remaining positive on UK equities following the election result. Our view on Asia ex-Japan as a whole is unchanged, but on a country level, we trimmed our China exposure given disappointment over the plenum, but still hold an overweight as further stimulus is expected. Meanwhile India exposure was increased, taking it to an overweight position versus the benchmark. Asian markets are very sensitive to falling US interest rates and therefore the markets of the region could be interesting once the Federal Reserve makes a move. In addition, the EMEA region could benefit but for now we remain neutral and the position is marginal.

Alternatives

Within alternatives we have marginally reduced our commodity exposure, taking it further underweight, with our only exposure being in gold. While there has been a recent pull-back in industrial metals we think that it is still too early to consider this as a buying opportunity, given that the OECD leading indicator has fallen into negative territory and so there may still be further declines. To balance out the moderate decrease in commodities, hedge fund positioning was raised, taking it to a modest overweight. Our overweight in insurance remains unchanged.

Important Information

The value of investments and the income derived from them can fall as well as rise, and past performance is no indicator of future performance. Investment products may be subject to investment risks involving, but not limited to, possible loss of all or part of the principal invested.

This document does not constitute and shall not be construed as a prospectus, advertisement, public offering or placement of, nor a recommendation to buy, sell, hold or solicit, any investment, security, other financial instrument or other product or service. It is not intended to be a final representation of the terms and conditions of any investment, security, other financial instrument or other product or service. This document is for general information only and is not intended as investment advice or any other specific recommendation as to any particular course of action or inaction. The information in this document does not take into account the specific investment objectives, financial situation or particular needs of the recipient. You should seek your own professional advice suitable to your particular circumstances prior to making any investment or if you are in doubt as to the information in this document.

Although information in this document has been obtained from sources believed to be reliable, no member of the EFG group represents or warrants its accuracy, and such information may be incomplete or condensed. Any opinions in this document are subject to change without notice. This document may contain personal opinions which do not necessarily reflect the position of any member of the EFG group. To the fullest extent permissible by law, no member of the EFG group shall be responsible for the consequences of any errors or omissions herein, or reliance upon any opinion or statement contained herein, and each member of the EFG group expressly disclaims any liability, including (without limitation) liability for incidental or consequential damages, arising from the same or resulting from any action or inaction on the part of the recipient in reliance on this document. The availability of this document in any jurisdiction or country may be contrary to local law or regulation and persons who come into possession of this document should inform themselves of and observe any restrictions. This document may not be reproduced, disclosed or distributed (in whole or in part) to any other person without prior written permission from an authorised member of the EFG group.

This document has been produced by EFG Asset Management (UK) Limited for use by the EFG group and the worldwide subsidiaries and affiliates within the EFG group. EFG Asset Management (UK) Limited is authorised and regulated by the UK Financial Conduct Authority, registered no. 7389746. Registered address: EFG Asset Management (UK) Limited, 116 Park Street, London W1K 6AP, United Kingdom, telephone +44 (0)20 7491 9111.

Independent Asset Managers: in case this document is provided to Independent Asset Managers (“IAMs“), it is strictly forbidden to be reproduced, disclosed or distributed (in whole or in part) by IAMs and made available to their clients and/or third parties. By receiving this document IAMs confirm that they will need to make their own decisions/judgements about how to proceed and it is the responsibility of IAMs to ensure that the information provided is in line with their own clients’ circumstances with regard to any investment, legal, regulatory, tax or other consequences. No liability is accepted by EFG for any damages, losses or costs (whether direct, indirect or consequential) that may arise from any use of this document by the IAMs, their clients or any third parties.