- U.S. small caps have closed the recent performance gap with large caps on hopes of a corporate tax cut, but a sustained run is more questionable.
- The week's tone was risk-on: Japan business confidence hit a 10-year high and annual emerging market equity inflows became the largest since 2010.
- U.S. third-quarter earnings season kicks off this week, with many banks reporting. U.S. headline retail sales will reflect post-hurricane auto sales.
Reigniting reflationary hopes lit a fire under global small-cap stocks in the past month. Prospects of a corporate tax cut fanned the flames in the U.S. given small caps' higher tax burden. But we believe a sustained run will require more than lower taxes.
Small-cap vs. large-cap performance and earnings revisions, 2016-2017
Sources: BlackRock Investment Institute, with data from Thomson Reuters, October 2017.
Notes: The green line shows U.S. small-cap stock performance relative to U.S. large-cap stocks since Oct. 3, 2016. The blue line shows relative earnings revisions over the same time period. Series are rebased to 100 as of Oct. 3, 2016. Small-cap stocks are represented by the S&P 600 Small Cap Index and large-cap stocks by the S&P 500 Index. It is not possible to invest directly in an index. Past performance is no guarantee of future results.
U.S. small caps enjoyed a performance boost post-election on hopes of a corporate tax cut and pro-growth policies. But they failed to capture an edge on U.S. large caps until August when prospects for tax reform regained momentum. U.S. small-cap returns have outpaced those of their large-cap counterparts by more than seven percentage points since Aug. 21. Analysts, meanwhile, have been downgrading small companies' earnings expectations for 2017, as shown in the chart, suggesting that enthusiasm for the group should be tempered.
Small caps are seen as big beneficiaries of a corporate tax cut. The median corporate tax rate for U.S. small caps was about 33% in 2016, compared with 29% for large caps, our calculations show. Hope that a deep corporate tax cut might come to fruition helped U.S. small-cap stocks make up almost all of the year-to-date underperformance of their large-cap counterparts in just six weeks' time.
But U.S. small caps have some hurdles to clear to win investors' affections longer term. Strong global economic growth and a weaker dollar are boons for large multinationals, which derive more of their profits overseas. Small-cap earnings estimates also are lagging. Analysts have revised down their 2017 and 2018 estimates by 8% and 6%, respectively, year-to-date. This compares to downgrades of just 1% and 2% for large caps. The trend is not new. Analyst downgrades of small-cap earnings estimates have outnumbered upgrades since 2011. Despite early-year optimism, actual earnings growth for small caps in 2017 is expected to be one-fifth that of larger companies. Disruption has played a role. Small-cap energy companies are still adapting to the shale revolution, and small consumer players are searching for an edge in a world with less brand power.
One result: a profit-margin gap between large and small U.S. companies that has more than doubled since the mid-1990s. Closing this gap will require improved small-cap sales growth. Valuations leave something to be desired as well. The S&P 600 Small Cap Index is trading at a lofty 21x forward earnings and the broader Russell 2000 Index of small-cap stocks at 27x, even after assuming a significant tax-cut-fueled earnings acceleration in the next 12 months.
Bottom line: U.S. small caps have impressed recently, but have become relatively expensive and vulnerable to any tax reform disappointment. Rather than size, we believe investors are better served focusing on equity style factors with potentially greater staying power in a sustained above-trend expansion, particularly momentum and value, as detailed in our Q4 Global Investment Outlook.
- The September U.S. jobs report revealed the first drop in new jobs in nearly seven years, largely attributed to hurricane-related business closures and, we believe, transitory.
- A risk-on sentiment prevailed. U.S. ISM data hit levels not seen since before the global financial crisis; Japan's Tankan survey showed sentiment among big manufacturers at decade-highs; and the total return of Japan's TOPIX touched its highest since 1990 this week. Flows into EM equity funds this year are now the largest since 2010.
- Spanish assets sold off, led by banks, as a result of the fallout from the Catalonian independence referendum. Chinese banks outperformed following the announcement of a cut to the reserve requirement ratio.
Weekly and 12-month performance of selected assets
|Equities||Week||YTD||12 Months||Div. Yield|
|U.S. Large Caps||1.3%||13.9%||18.0%||2.0%|
|U.S. Small Caps||1.3%||12.4%||22.8%||1.2%|
|U.S. Investment Grade||0.0%||5.2%||2.8%||3.2%|
|U.S. High Yield||0.2%||7.2%||8.6%||5.4%|
|Emerging Market $ Bonds||0.1%||9.1%||5.0%||5.2%|
|Brent Crude Oil||-3.3%||-2.1%||5.9%||$55.62|
Source: Bloomberg. As of October 6, 2017
Notes: Weekly data through Friday. Equity and bond performance are measured in total index returns in U.S. dollars. U.S. large caps are represented by the S&P 500 Index; U.S. small caps are represented by the Russell 2000 Index; Non-U.S. world equity by the MSCI ACWI ex U.S.; non-U.S. developed equity by the MSCI EAFE Index; Japan, Emerging and Asia ex-Japan by their respective MSCI Indexes; U.S. Treasuries by the Bloomberg Barclays U.S. Treasury Index; U.S. TIPS by the U.S. Treasury Inflation Notes Total Return Index; U.S. investment grade by the Bloomberg Barclays U.S. Corporate Index; U.S. high yield by the Bloomberg Barclays U.S. Corporate High Yield 2% Issuer Capped Index; U.S. municipals by the Bloomberg Barclays Municipal Bond Index; non-U.S. developed bonds by the Bloomberg Barclays Global Aggregate ex USD; and emerging market $ bonds by the JP Morgan EMBI Global Diversified Index. Brent crude oil prices are in U.S. dollars per barrel, gold prices are in U.S. dollar per troy ounce and copper prices are in U.S. dollar per metric ton. The Euro/USD level is represented by U.S. dollar per euro, USD/JPY by yen per U.S. dollar and Pound/USD by U.S. dollar per pound. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future results.
Asset class views
Views from a U.S. dollar perspective over a three-month horizon
This post originally appeared on the BlackRock Blog.