Global Allocation Insight

Are small caps signaling a smaller risk appetite?

Apr 18, 2017 / By Russ Koesterich, CFA, JD

U.S. stocks got off to a stellar start this year. Looking below the surface, however, small cap performance reveals an interesting trend.

U.S. stocks got off to a stellar start this year. Looking below the surface, however, reveals an interesting trend. Small cap stocks, which led the pack toward the end of 2016, have trailed in the first quarter of 2017, with the Russell 2000 Index returning only 1.5% compared to 5.5% for the S&P 500. What accounts for the reversal and will it continue? We see two potential causes: risk appetite and valuation.

As the “reflation tradethat began in mid-2016 has started to struggle, investor risk tolerance appears to be shifting. To gauge this trend, we look to credit, particularly high yield. Since 2000, monthly changes in high yield spreads have explained roughly 10-15% of small cap’s relative performance. The recent pull back in appetite for high yield bonds may be interpreted as a dampening willingness to take on risk, which may manifest in weaker demand for small cap stocks. In addition, while neither large nor small cap U.S. stocks are cheap, small caps look particularly pricey. The Russell 2000 was already expensive last December, and now at nearly 48 times trailing earnings, it is even more so. Not surprisingly, many investors are starting to look for better bargains overseas.

U.S. small cap outperformance has narrowed as the “reflation trade” struggles

Chart: U.S. small cap outperformance has narrowed

Source: Bloomberg, March 31, 2017. U.S. Small Cap Stocks represented by the Russell 2000 Index. U.S. Large Cap Stocks represented by the S&P 500 Index.

In the absence of progress on tax reform and infrastructure spending, investors may be looking at a more modest version of the reflation trade than what was priced into the market last fall. Given the prospect of diminishing risk appetite amid expensive equity valuations, we have opportunistically added to the BlackRock Global Allocation Fund’s position in gold and reduced the weighting in the U.S. dollar. Within fixed income, we have added to U.S. Treasuries and reduced exposure to credit.

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Portfolio highlights

  • While the economic backdrop in the U.S. remains healthy, confidence indicators are materially outpacing changes in actual economic activity. Given this divergence, coupled with expensive valuations, we prefer non-U.S. equities, notably in Japan and Europe.
  • We added to energy stocks, particularly in Europe, based on relatively attractive forward-looking cash flow multiples and attractive dividend yields.
  • We modestly increased the fund’s weighting in U.S. Treasuries and investment grade fixed income and reduced exposure to high yield debt and bank loans.

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