Small-Cap Industrials

Small-Cap Perspective

Co-CIO Francis Gannon on what increased volatility, lower returns, and low interest rates mean for the small-cap market.

Q1 hedge fund letters, conference, scoops etc

Small-Cap Industrials

User:klip game [Public domain], via Wikimedia Commons

What’s your perspective on where we are in the small-cap market?

One of the more interesting aspects of the market this year, especially following the first quarter of 2019, is the fact that you’re seeing outlook statements from many of the companies be better than people have anticipated. And for all intents and purposes, the earnings recession which people worried about dramatically in the latter part of 2018 could be effectively behind us.

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The opportunity from our perspective, and maybe what’s not priced in the market yet, is that global economic growth could actually be doing better than people think. You’re starting to see green shoots of economic optimism coming out of China, potentially out of Europe. Still very early, very nascent, but I think that is setting the table for the latter part of the year in terms of the overall market.

What did you make of the market plateauing since February?

There’s two types of corrections in the market that we’ve always talked about. One is obviously price. You can see a large price correction like we did in the latter part of last year. And the other one is time. And I think the market has been digesting a really powerful move that we saw in the first two months of this year through March, April and into the beginning of May here, and I think that’s significant. It’s giving earnings a chance to catch up with the overall market from a valuation perspective here.

Small-Cap Plateau?
Russell 2000 Daily Index Values YTD Through 5/9/19

What’s your perspective on where we are on the road to normalization?

I think we are continuing on the road to normalization. Over the past several years we’ve focused on this idea that we are entering a more normal period of time, and we can debate on what normal might be, but normal for us really is around three things: increased volatility, lower returns for the overall market, and a more normal interest rate environment.

I think of those three, we continue on that road, especially around volatility. While volatility seemed to quiet in the first quarter of this year, when the market was up, I think if you put it in context of the past six months, the fourth quarter and the first quarter, you had very high volatility in what was a very topsy-turvy market, right? Where the market at the end of the first quarter still being down off its all-time highs. The volatility story is a really good one for active managers. It gives us the opportunity to take advantage of dislocations in the market as they occur.

The second thing has been returns. We’ve talked about a more normal return environment. The one-year numbers for the Russell 2000 at the end of the first quarter from a return perspective are just 2%. The five-year numbers are 7%. Much lower than we’ve seen in a period of time. So we think we’re going to have more lower returns, but still okay returns.

Low return environment typically means participation from all areas of the market, and therefore a better environment for active managers going forward. The interest rate story on the road to normalization here has been obviously a little interesting this year, especially with the 10-year coming down so dramatically at the end of the first quarter and the curve inverting for a period of time.

And I think that the interest rate story is not perfect at the moment in this road to normalization, but I think it’s something investors have to continue to focus on because of the increased amount of corporate debt out there, especially within small-cap companies, that investors are really not focusing on.

Article by Francis Gannon, The Royce Funds


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