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Market View

With smaller companies having greater exposure to an expanding U.S. economy, this may be an opportune time to consider an allocation to U.S. small-cap stocks.

 

In Brief

  • The recent outperformance of U.S. small-cap stocks versus their large-cap peers has been almost perfectly aligned with the recent strengthening of the U.S. dollar.
  • Small-cap companies have greater U.S. revenue exposure than large caps.
  • Investors may be wise to increase their exposure to the small-cap sector of the market.

 

As discussed in a recent Market View, there are many reasons for the recent outperformance of U.S. small-cap stocks relative to their large-cap peers, ranging from trade fears to tax cuts. But perhaps the most powerful force behind their outperformance—one that we believe might persist for the foreseeable future—is the long-overdue strengthening of the U.S. dollar.

In both economic theory and practice, a rising fed funds rate should lead to a strengthening dollar. From a purely theoretical perspective, U.S. Federal Reserve (Fed) rate hikes are by their nature anti-inflationary—that is, designed to reduce the velocity of money and increase saving. In practice, tighter financial conditions historically have led to investors seeking stability in, and thus strengthening, the U.S. dollar, the world’s reserve currency.

 

Chart 1. The Relationship Between the Dollar and Fed Funds Rate Is Finally Normalizing
U.S. Dollar Index versus fed funds rate, December 16, 2015–June 16, 2018

Source: Morningstar. U.S. dollar is represented by the U.S. Dollar Index (USDX).  For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

However, since the Fed began its most recent tightening cycle in 2015—and until very recently—the  positive correlation between dollar strength and the fed funds rate has not held. The Fed has hiked interest rates seven times, in 25 basis-point increments, since December 16, 2015.  During this period, the U.S. dollar (as measured by the U.S. Dollar Index) has, albeit in fits and starts, declined by more than 4%. In fact, at its nadir on February 16, 2018, the dollar was down nearly 10% from where it was when the fed funds rate was last at 0%, a little more than two years prior. What makes this negative correlation even more unusual is that the United States was, and remains, well ahead of the rest of the world when it comes to monetary tightening, which should have made the dollar even more relatively attractive.

In recent months, however, the relationship between the dollar and fed funds rate appears to be normalizing. Since the dollar’s bottom on February 16, the currency has advanced nearly 7% alongside two more Fed rate hikes. In addition, this recent strength is supported by the relative momentum of the U.S. economy in comparison to the rest of the world. While global growth continues to broadly accelerate after a strong year in 2017, it has become evident this year that the U.S. economy is carrying much of the load. U.S. gross domestic product (GDP) growth has remained steady over the past year, with estimates of second-quarter GDP suggesting year-over-year growth of more than 3%, and economic fundamentals, including capital spending, consumer confidence, and the jobless rate, show no signs of this sustained growth letting up in the near future.

For investors, the potential for a period of persistent dollar strength should signal an opportune moment to consider the merits of U.S. small-cap stocks in their portfolios. As illustrated in Chart 2, smaller-cap companies tend to be more domestically oriented than their large-cap peers that often derive revenue from sources across the globe. For these large-cap multinational companies, a strengthening dollar may weigh on their overseas revenues.

 

Chart 2. Small-Cap Companies Have Greater U.S. Revenue Exposure Than Large Caps
Revenue exposure, by market capitalization, on fiscal year 2017 revenue estimates

Source: FactSet. Domestic sales as a percentage of total geographic sales. Segments are collected as reported in its respective index. If a company reports by region instead of country, the total domestic sales are based on the home country’s or country of domicile’s region. Small-cap company stocks tend to be more volatile and may be less liquid than large-cap company stocks. Mid-cap companies typically experience a higher risk of failure than large-cap companies.  Small-cap companies also may have more limited product lines, markets, or financial resources, and typically experience a higher risk of failure than large-cap companies.  For illustrative performance only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.  Forecasts and projections are based on current market conditions and are subject to change without notice.  Projections should not be considered a guarantee.

 

It seems investors have received this message, as the recent outperformance of small-cap stocks has been almost perfectly aligned with the recent strengthening of the dollar. Since the currency’s bottom on February 16, small-cap stocks (as measured by the Russell 2000® Index) have advanced by more than 9%, dramatically outpacing large-cap stocks (as measured by the Russell 1000® Index), which have returned less than 1%.

 

Chart 3. Recently, Small-Cap Outperformance Has Been Aligned with a Strengthening U.S. Dollar
U.S. Dollar Index versus small-cap outperformance,* February 16–June 16, 2018

Source: Morningstar.  U.S. dollar as measured by the U.S. Dollar Index (USDX). *Small-cap stocks represented by the Russell 2000® Index minus large-cap stocks represented by the Russell 1000® Index. Past performance is not a reliable indicator or a guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

As the Fed continues to signal additional rate hikes over the course of 2018, it seems likely that the dollar should continue to strengthen, returning to its more normal relationship with U.S. interest rates. In addition, the U.S. economy continues to exhibit relative strength, further supporting a strong dollar and domestically oriented companies. With these tailwinds in place and small-cap stocks already beginning to reverse a prolonged period of underperformance, investors may be wise to look for ways to increase their exposures to this area of the market that, historically and over the long term, has been a powerful driver of alpha.

 

A Note about Risk: The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Small cap company stocks tend to be more volatile and can be less liquid than large cap company stocks. Small and Mid-cap companies may be less able to weather economic shifts or other adverse developments than larger more established companies. Small cap companies also may have more limited product lines, markets, or financial resources and may be more susceptible to setbacks or economic downturns. No investing strategy can overcome all market volatility or guarantee future results.

Diversification does not guarantee a profit or protect against loss in declining markets.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.

Glossary of Terms

Alpha is defined as the excess return of a mutual fund relative to the return of the benchmark index.

A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01% (1/100th of a percent) or 0.0001 in decimal form.

Correlation is a statistical measure that indicates the extent to which two or more variables fluctuate together. A positive correlation indicates the extent to which those variables increase or decrease in parallel; a negative correlation indicates the extent to which one variable increases as the other decreases.

The U.S. Dollar Index (USDX) is a measure of the value of the U.S. dollar relative to the value of a basket of currencies of the majority of the U.S.'s most significant trading partners.

The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.

The Russell 2000® Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The Russell Midcap® Index measures the performance of the 800 smallest companies in the Russell 1000 Index, which represent approximately 31% of the total market capitalization of the Russell 1000 Index.

The Russell Top 200® Index measures the performance of the 200 largest companies in the Russell 1000 Index, which represents approximately 68% of the total market capitalization of the Russell 1000 Index.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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