What's Driving The U.K. Small-Cap ETF Rally?
British small-cap stocks have lately held up pretty well despite a falling pound and the yet-to-be-seen impact of Brexit. However, small-cap stocks are lagging the large caps as evident by a 9.8% year-to-date (as of August 15, 2016) decline in iShares MSCI United Kingdom Small-Cap ETF (BATS:EWUS) versus about 16% gains noticed in WisdomTree United Kingdom Hedged Equity ETF (NASDAQ:DXPS).
Upbeat Economic Indicators
A host of reasons are behind this rebound in small caps. First, the British Retail Consortium “reported that like-for-like sales in the UK rose by 1.1% in the four-week period to July 30 compared with the same period a year ago.” In fact, July sales bounced back from a fall in June, shrugging off all Brexit-related fears.
The data indicated that even after Brexit in late June, Britons did not axe retail spending – one of the key barometers of economic well-being. The British economy expanded 2.2% year over year in Q2, pacing ahead of a 2% increment in the prior quarter. The figure also exceeded market expectations of a 2% rise. It was the best growth rate logged by the British economy.
Policy Easing by BoE
In such an upbeat scenario (at least seen so far), the Bank of England (BoE) cut interest rates by 25 basis points to a rock-bottom 0.25% for the first time in more than seven years. This was to contain any negative impact of Brexit and boost economic growth further.
The BoE is also buying back 10 billion pounds or (about $13 billion) of corporate bonds under a new stimulus package. These company bonds will be investment-grade and non-financial in nature. Thanks to this move, yields on corporate bonds will be reduced and the cost of borrowing for companies will come down, as per BoE. Also, BoE will make sure that the banks fully convey this rate-cut effect to borrowers.
If the banks do so, consumer spending is likely to rise on lower rates of interest. Also, investors should note that in light of the BoE rate cut, a look at small-cap stocks is warranted. This is because small-cap stocks rebound more than the larger ones when the domestic economy picks up. These pint-sized stocks are less affected by global market turmoil than their larger counterparts.
Commodity Rally
Along with the aforementioned factors, pricing gains in “minerals, resources and energy companies among UK-listed minnows” gave a boost to small-cap UK stocks, as per Financial Times. The agency also noted that “the two best-performing stocks in the FTSE SmallCap index this year are Ferrexpo (OTC:FEEXF) and Lonmin (OTC:LNMIF), up 252% and 186% respectively.”
Recent Strength in Pound
With the British currency pound – which slipped to a 31-year low – gaining strength as evident by over 1.2% returns offered by CurrencyShares British Pound Sterling ETF (NYSEARCA:FXB) on August 16 due to the higher-than-expected July inflation data, the case for small-cap investing becomes stronger. Inflation level has been at its peak since November 2014 as import prices are steep post Brexit.
If the winning trend in pound stays for some more time, small-caps will not be affected by foreign currency translations due to their lower foreign exposure.
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Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
