Small cap performance and rise in interest rates are lately very correlated. Climbing rates argue about more optimism in the economy. Since the markets are forward-looking, we can expect outperformance from small cap stocks compared to the broader market. So far this year, the Russell 2000 is up 13% while the broader market is up 20%. So, it is not a bad idea to be long small caps as participants become more risk taking going into the end of the year.
Last year, the 10 year yields rose from 31 basis points to as high as 1.78% and so did the small cap stocks. If you overlay the charts, you can see that as interest rates declined to 1.13% on the ten years, small caps declined as well. Now, interest rates are on the rise again and small caps are looking perky as well.
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There are a few reasons for the pick up in rates. The main thing is the optimism on the economy. Secondly, the FDA’s vaccine approval sort of rubber-stamped further regulator approvals and subsequent widespread vaccine mandates.
The US Congress is about to affix a stamp of approval on the $1.9 trillion Biden spending package. Another $4.5 trillion is also waiting in the wings for the Congress to approve this week. That’s a lot of money for our small brains to comprehend. There will be a sea of liquidity which will keep the tides higher as we discussed in many past letters.
Since the FDA news, ten year yields are already higher by 10 basis points. Yesterday, the German yields had the biggest move since March. Italian yields one of the weakest spots in Europe jumped up by 9 basis points, this is the biggest up move since last February. To top it up, the Fed is talking the rates up too.
What does this all indicate? As long as the sea of liquidity is in play, the tides will continue to rise. We do not know when the tide will recede, but when it does (and it surely will), we will also know all who were swimming naked!
Abraham George is a seasoned investment manager with more than 40 years of experience in trading & investment and portfolio management spanning diverse environments like banks (HSBC, ADCB), sovereign wealth fund (ADIA), a royal family office and a hedge fund.