New Liking for U.S. Small Caps, Continued Affinity for Asia
Against this broad backdrop, one segment of the U.S. market that is showing signs of improvement is small-cap stocks. After dramatically underperforming year-to-date, we are starting to see some shift in sentiment. We had been advocating an underweight to U.S. small caps all year, but would now favor a more neutral stance.
While the U.S. experienced an exceptionally quiet week, equity markets in Asia were livelier. We continue to see good opportunities in these markets, which have been outperforming of late.
Japanese stocks surged 3% last week to a six-year high (although it surrendered most of those gains on Monday), driven by good earnings, the weakening yen and hopes that an expected tax hike will be delayed. According to local reports, Prime Minister Abe is likely to call a snap election around mid-December and postpone the sales tax increase scheduled for next October.
In China, stocks continued to rally despite weaker economic growth there. The Shanghai Composite Index rose 2.8% to a three-year high after officials approved the launch of the Hong Kong-Shanghai trading link. Until now, overseas investors were largely limited to trading on the Hong Kong exchange. The new program will give overseas investors access to $2 trillion in Chinese equities, which could be supportive of stocks there.
Commodity Volatility Picks Up
While volatility in stocks and bonds is down, it is picking up for commodities. Before rebounding on Friday, both gold and oil traded to new lows for the year. Brent oil traded below $80 per barrel for the first time since 2010. At the same time, gold prices temporarily dipped below $1,150 per ounce. Gold was hit earlier in the week by news that Chinese demand contracted for a third consecutive quarter.
Gold managed to rebound on Friday, but several factors are still conspiring against the metal: a strong dollar, the prospect for rising real interest rates (in other words, the interest rate after inflation), and declining inflation expectations. Indeed, the University of Michigan Consumer Sentiment Survey showed U.S. inflation expectations declining from 2.8% to 2.6% last month. As such, we would continue to be cautious on gold in this environment.