In Small Caps, Financials Rise Most From GDP Growth

On Friday morning the GDP (Gross Domestic Product) for Q2 2018 is set to be announced, and the consensus estimate from the Wall Street Journal survey of more than 60 economists is at 4.1%, the highest (actual) growth since Q3 2014.  Although forecasts greatly vary this quarter, the main factors likely influencing growth are tax policy, retail sales, international trade and manufacturing shipments.

Source: http://projects.wsj.com/econforecast/#ind=gdp&r=12

While U.S. GDP growth is beneficial for stocks in general, the growth has been better for small caps than for large- or mid-caps.  On average for every 1% of GDP growth, the S&P SmallCap 600 has risen 5.2%, while S&P MidCap 400 and S&P 500 have risen a respective 4.9% and 4.0%.  Within small caps, the financials, health care and energy sectors have risen most with growth, gaining on average 6.9%, 6.4% and 6.3%, respectively for every 1% of GDP growth.

Sources: S&P Dow Jones Indices and Bureau of Economic Analysis, U.S. department of Commerce. https://www.bea.gov/national/index.htm#gdp  Data is Gross Domestic Product percent change from preceding period, annual. S&P 600 and sector data is from 1995 – Dec 2017, except Real Estate is from 2002. All Data ending Dec. 29 ,2017. Index data is Total Return.

Although in small caps, financials have delivered 50 basis points more of return than health care from each 1% of GDP growth on average, the financial small cap premium is by far the most sensitive to GDP growth.  For every 1% of GDP growth on average, small cap financials have returned 2.4% more than large cap financials.

Sources: S&P Dow Jones Indices and Bureau of Economic Analysis, U.S. department of Commerce. https://www.bea.gov/national/index.htm#gdp  Data is Gross Domestic Product percent change from preceding period, annual. S&P 600 and sector data is from 1995 – Dec 2017, except Real Estate is from 2002. All Data ending Dec. 29 ,2017. Index data is Total Return.

One contributing factor for the relatively large financials small cap premium is the percentage of revenues that are generated domestically from the small caps versus large caps.  The small cap financials generate about 95% of revenues from the U.S., 17% more than the large cap financials.  The result is the small cap premium in financials is 10.6% year-to-date through July 26, 2018.  While all 3 industry groups of the small cap financials outperformed their large cap counterparts, the small diversified financials outperformed most by 13.5%, just ahead of the small cap outperformance by insurance of 12.8%, and more than the 8.4% premium of small banks.

Source: S&P Dow Jones Indices. Small cap premiums are measured by price return of S&P 600 minus S&P 500 year-to-date through July 26, 2018. The sector is in darkest blue, industry groups are medium blue, industries are light blue and sub-industries are light gray with a blue outline. Only groups with stocks in both large cap and small cap are displayed.

Within the diversified financials, the small cap premium was greatest from the consumer finance industry that may be attributed to strong consumer spending that accounts for more than two-thirds of U.S. economic activity, and is likely being driven by lower taxes and a robust labor market.  Similarly, small consumer staples have been more greatly benefiting than their large cap counterparts, outperforming by 16.6% YTD.  Also contributing to the small cap premium in financials is the life and health insurance sub-industry and the insurance broker sub-industry, with respective small over large performance of 28.3% and 24.3%.  This goes along with the small health care companies have been outperforming their large counterparts significantly this year by an impressive 31.3%.

As U.S. GDP growth accelerates, small cap stocks may continue to outperform large caps, but only if there is quality as in the S&P 600.

The posts on this blog are opinions, not advice. Please read our disclaimers.

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