Stocks continue recovery amid optimism. Following the early August sell-off, stocks rebounded strongly with Nasdaq leading the recovery, up 5.3% for the week, followed by the S&P 500, up 3.9%. This was supported by positive retail sales and cooling inflation data, its lowest reading in more than three years. However, the housing sector showed signs of strain with building permits and housing starts dropping to their lowest levels since the early pandemic.

European markets rallied alongside the US, buoyed by expansion of the Eurozone economy, +0.3% in 2Q. The Euro STOXX 50 and Dax were up 3.5% and 3.4% for the week. Over in Japan, the Nikkei 225 was up 8.7%, supported by a weaker yen and stronger than expected US economic data. China, on the other hand, saw modest gains despite posting weaker-than-expected industrial production numbers and continued declines in new home prices. The SHCOMP and Hang Seng were up 0.6% and 2.0% for the week.

Topic in focus: Tactical play on small caps as Fed policy eases. On Wednesday (14 Aug 2024), July’s CPI numbers came in lower than expected (2.9% y/y vs consensus 3.0% y/y), and it marks the first time since Mar 2021 that CPI has fallen below 3%. This strengthens the case for initiating a rate cut cycle in September which will likely benefit small caps. Medium-term momentum for the small caps space include:

1. Rate cuts and lower borrowing cost to buoy small caps earnings: Small caps companies have a larger proportion of debt maturing within five years as compared to larger companies (c.67% for S&P 600 Small Cap vs c.45% for S&P 500). As the Fed embarks on monetary easing, small cap companies will be able to refinance at lower rates, reduce their borrowing cost, and boost earnings.
2. Fund flows suggest renewed interest in US small caps as rate cuts loom: In the three months before June's CPI data release, small cap equity funds saw weekly outflows. Since the release of June’s data (which fuelled expectations of a September cut), small cap equity funds attracted a combined inflows of USD11bn in four weeks (ending 7 Aug).
3. Attractive “broadening rally” play amid steep valuation discount: At 17.7x, the S&P 600 Small Cap index’s forward P/E is currently well below its 20-year average. Above all, the index is also trading at a 22.9% discount to the S&P 500.