Recent market volatility has masked some fairly significant global performance rotation. 

Small and mid caps have outperformed over the past four to five weeks, while a number of equity sectors have outperformed the high-flying US tech sector.

This follows an extended period of narrow outperformance centred on a small number of US mega cap technology companies. The prospect of relatively imminent Fed rate cuts (from September) was the initial catalyst for the improved relative performance of alternative “investing styles” and sectors other than mega cap tech.

The release of an unexpectedly low CPI on July 10 correlates closely with the initial rotation, as expectations for a September start to a Fed easing cycle picked up significantly. Improved performance from small/mid caps is one clear example of this performance rotation. This shift in interest rate expectations has driven a pullback in mega cap tech, and a renewed interest in areas like small/mid caps for a number of reasons.

The monetary policy cycle has tended to be important for considering the relative performance potential of small caps. Small cap equities have historically outperformed large caps in the year after an interest rate peak as policy is eased. On average, global small caps have outperformed large caps by more than 10%.

The rationale seems to be multi-faceted. Small caps tend to be more sensitive to economic conditions. Small caps also tend to have more leveraged balance sheets and finally, small caps tend to perform better in periods of improved monetary liquidity.

Valuations for global small and mid caps (SMIDs) have looked attractive for some time, but the market has lacked a catalyst for the shift away from the relatively narrow performance trend that had been dominating global equities for some time.

While the Fed’s monetary policy pivot looks to be a promising catalyst for broader (or different) market leadership, we are cognizant of the risk posed by the lagging impact of tighter monetary policy. A bigger than anticipated slowdown in the US economy would not be supportive for US/global small cap outperformance, and would likely be a headwind for investing styles such as value strategies. 

However, in our view, there are encouraging signs of a soft landing scenario for both the US and the global economy. The market wobbled in early August on US recession fears. In our view, however, recent solid economic data does not appear consistent with a US recession.

Recent volatility may persist, with valuations that look compelling, and the prospect of easier monetary policy delivering a soft landing in the US and probably improved growth outside the US. We nonetheless expect the small/mid company asset class to perform well over the coming year, and most likely beyond.

The other influence on the recent better performance from other areas of the market (relative to big tech) was the US reporting season. As we discussed last week, the mega cap technology shares did not react as positively to results as they have in previous reporting seasons. This likely reflects the reality that considerable expectation had built up in tech share valuations in recent months.

US tech still looks to have a strong growth outlook. However, the recent US reporting season shows that there isn’t much margin for error from a valuation and investor positioning perspective. We would note that US tech has once again bounced fairly hard post the recent short and sharp global correction in early August. 

In spite of the sharp bounce back in big tech, we still feel a number of factors favour broader market performance. Valuations are relatively attractive in the global equity market ex-US and/or ex-tech. At the sector level, energy and global REITs look particularly attractively valued. As discussed, valuations alone are not a great market timing tool. However, cheap valuations combined with a monetary easing cycle and the prospect of a global soft landing appear supportive for a reasonably solid corporate earnings cycle. Earnings growth should be more even across the market than it has been over the past year (figure 5).

In our view, a confluence of factors suggests casting the investment net beyond US tech. A US/global slowdown still presents a risk to the rotation trade, given areas like small caps, value stocks and non-US equities tend to be more cyclical on average. However, our central case is nonetheless for a soft landing, while a quality overlay should improve the risk-return trade-off for many of these alternative equity strategies.