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Expectations that the U.S. economic rebound will slow in the second half are weighing on small cap stocks, forcing fund managers to look for companies that could continue to profit in a lower growth environment.

The Russell 2000 index, which tracks smaller companies, has underperformed the S&P 500 in each of the last four months. Investors pulled nearly $108 million out the iShares Russell 2000 index exchange traded fund during the week that ended July 14, the third straight week of outflows that combined to total nearly $965 million and represent the ETF’s longest losing streak since April.

Small caps stocks have been among the beneficiaries of the so-called reflation trade, which also saw investors bet on shares of banks, energy firms and other economically sensitive companies and lighten up positions in U.S. Treasuries on expectations of a powerful economic rebound. The Russell 2000 is up 11.6%this year, compared to an 16.3% rise for the S&P 500.

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Some now believe that bounce has run its course and the economy will slow in coming months, sparking a rotation back into the technology and high-growth stocks that have led markets higher over the last decade.

Yields on the benchmark 10-year Treasury, which move inversely to prices, edged higher Friday but remained near their lowest levels since February. In testimony before Congress earlier this week, Federal Reserve Chairman Jerome Powell said rising inflation is likely to be transitory and that the U.S. central bank would continue to support the economy, adding to pressure on yields.

“We have perhaps passed peak inflation fears, and we’ve also passed peak growth optimism,” said Brian Jacobsen, senior investment strategist at Wells Fargo Asset Management.

His firm has been paring its overweight on small caps and is now neutral on the asset class due to expectations that the economic boom from the coronavirus recovery will be short-lived.

Overall, fund managers have unwound their bullish bets on small caps relative to large caps back to levels last seen in October 2020, before the announcement of effective coronavirus vaccines helped fuel an outsized rally in cyclical and small-cap stocks, according to a global survey of fund managers by BofA Research.

Low bond yields will likely continue to weigh on small-caps as investors opt for sources of income such as dividend stocks rather than look for capital gains, said Lamar Villere, a portfolio manager at Villere & Co.

“People are trying to chase any yield that they can and that comes at the expense of small caps. You’ve got this huge demand on the client side for blue chip dividend paying stocks right now because it’s the only place you can get any sort of yield,” he said.

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His firm has not added any new positions in small-caps over the last six months, he said, and has instead added companies such as media giant Viacom Inc to its portfolios.

Investors will get additional clues as to how broadly the U.S. economy is expanding in the week ahead through data showing new housing starts on Tuesday and an index of leading economic indicators on Thursday.

Netflix and Twitter, meanwhile, are also expected to release their latest quarterly earnings results in the week ahead, giving investors a deeper read into how the reopening of the economy has affected revenue growth.

Signs that high inflation will persist longer than the Fed expects could bolster small caps, said Jim Paulsen, Chief investment strategist at the Leuthold Group.

Overall, the Russell 2000 should post a 50% growth in earnings over the 2021 fiscal year, compared with a 44% earnings growth in the large-cap S&P 500, according to Jefferies.

That outsized growth rate and high valuations in the S&P 500 could make small caps a contrarian play over the remainder of the year, said Saira Malik, chief investment officer of global equities at Nuveen, who said that she has been adding to financials in expectation that the 10-year Treasury yield will end the year near 2%.

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“We definitely think it will be tougher in the second half, but there will be some permanence to inflation and that would be positive to small caps,” she said.

-- David Randall, Reuters

This is the Globe Investor newsletter, published three times each week. If someone has forwarded this e-mail newsletter to you or you’re reading this on the web, you can sign up for the newsletter and others on our newsletter signup page.

Stocks to ponder

Stelco Holdings Inc. (STLC-T) The steel producer’s stock is up more than 1,000 per cent since the dark early days of the pandemic - and analysts are unanimous in believing more gains are on the way. Some are also expecting special dividends in the near future, in addition to Stelco’s regular dividend payout. Brenda Bouw tells us more.

Neighbourly Pharmacy Inc. (NBLY-T) This company operates 146 pharmacy stores across the country and since its May IPO, has skyrocketed nearly 70 per cent. Jennifer Dowty explains why the stock is worth putting on your radar screen.

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The Rundown

The loonie is sinking fast – and the Fed is to blame

The Canadian dollar has been losing ground over the past two months, but don’t pin the blame on softer commodity prices, shifting Bank of Canada monetary policies or general risk aversion among global investors. Instead, the loonie’s retreat appears largely driven by a widespread belief the U.S. Federal Reserve will tighten its monetary policy sooner than was expected earlier this year, because of a recovering economy and rising inflation expectations. David Berman explains

Others

The highest-yielding stocks on the TSX, plus risk data

Friday’s analyst upgrades and downgrades: Major U.S. bank turns cautious on Telus; Shopify gets highest-ever price target

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Thursday’s analyst upgrades and downgrades

Number Cruncher: The top 15 U.S.-listed stocks with a solid earnings history

Globe Advisor

New accreditation may lead to growth in use of the ‘Smith Manouevre’

Are you a financial advisor? Register for Globe Advisor (www.globeadvisor.com) for free daily and weekly newsletters, in-depth industry coverage and analysis, and access to ProStation - a powerful tool to help you manage your clients’’ portfolios.

Ask Globe Investor

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Question: I wish to buy Canadian stocks for my non-registered account with U.S. dollars withdrawn from my registered retirement income fund in order to take advantage of the dividend tax credit. I would also like to avoid paying the currency conversion costs of switching my U.S. dollars to Canadian dollars. Are dividends of Canadian companies purchased on a U.S. exchange with U.S. dollars eligible for the dividend tax credit?

Answer: Scores of Canadian companies – including banks, railroads, pipelines, telecoms, insurers and utilities – are inter-listed on a U.S. exchange such as the NYSE or Nasdaq. If the company’s dividends are eligible for the enhanced dividend tax credit, it doesn’t matter where you purchase its shares in Canada or the U.S.; you’ll get the DTC either way.

If you aren’t sure whether a company’s dividends qualify for the DTC, read its latest dividend announcement. It will specify if the payment is an “eligible dividend” for tax purposes.

Assuming you already have U.S. cash on hand, buying Canadian shares in U.S. dollars on a U.S. exchange can save you money, because you’ll avoid the spread of 1 to 2 per cent that brokers typically pocket by converting your U.S. funds to Canadian dollars at exchange rates that are favourable to them.

If you wish, you can then ask your broker to “journal” the shares to the Canadian side of your account so that the dividends will be received in Canadian dollars. If you leave the shares on the U.S. side, your dividends will usually be paid in U.S. dollars. That’s how it works at my discount broker, but you should verify this with your own broker.

Just to be clear, if you don’t already have U.S. dollars to invest, there is no advantage to purchasing Canadian stocks on a U.S. exchange. You’ll just pay unnecessary currency conversion costs. In such cases, you would be better off buying the shares on a Canadian exchange.

--John Heinzl

What’s up in the days ahead

Brenda Bouw talks to Kash Pashootan to see what the portfolio manager has been buying and selling of late.

Click here to see the Globe Investor earnings and economic news calendar.

More Globe Investor coverage

For more Globe Investor stories, follow us on Twitter @globeinvestor

You may also be interested in our Market Update or Carrick on Money newsletters. Explore them on our newsletter signup page.

Compiled by Globe Investor Staff

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