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Mar 13, 2019

BlackRock urges caution on smaller companies

Small-cap rally not worth chasing, says investment strategist Richard Turnill

Global small-cap stocks have had a strong 2019, outperforming large caps by more than 3 percentage points, but this is not a rally worth chasing, according to Richard Turnill, BlackRock’s global chief investment strategist.

As the pace of the global expansion slows, BlackRock prefers large-cap equities, notes Turnill in an investment outlook, favoring exposure to firms with ‘quality markers such as strong balance sheets’.

Turnill observes that small caps tend to be more domestically oriented than large caps and have a slightly more cyclical sector composition, with a greater representation in sectors such as construction, real estate and manufacturing. ‘This means they are more sensitive to changes in economic activity,’ he writes.

Global small caps’ relative performance has historically shown a tight relationship with swings in global Purchasing Managers’ Index (PMI) data, he adds: ‘Global composite PMIs have mostly fallen over the past year, with small-cap performance following suit – until this year. Small caps have roared back to life, with only a modest recent bounce-back in PMI data.

‘We attribute much of the small-cap move to multiple expansion amid the fading of key risks to the macro outlook: higher rates and escalating trade conflicts. More dovish monetary policy guidance from central banks globally and a lessening of perceived geopolitical risk have provided relief for risk assets – and for small caps, too.’

Ultimately, Turnill asserts: ‘We see fewer catalysts for sustained small-cap out-performance ahead. Small caps tend to have higher operational leverage and less diversified businesses than larger companies in the same sectors. This leaves them less resilient during periods of decelerating growth and rising uncertainty, like the one we see ahead in 2019 as the US economy enters a late-cycle phase.’

He says today’s late-cycle economic environment of slowing growth and rising uncertainty calls for carefully balancing risk and reward. ‘We advocate building portfolio resilience through high-quality exposures and caution toward lower-quality market segments, such as small caps,’ he concludes.