Small caps expected to outperform as ‘three green lights’ flash: Escala

Economic signals are ‘setting the scene’ for a period of outperformance by small cap stocks, says Escala Partners’ chief investment officer.

Economic signals are ‘setting the scene’ for a period of outperformance by small cap stocks, says Escala Partners’ chief investment officer Tracey McNaughton. Picture; Britta Campion

Australia has two economic “green lights” and a third should come with the winding back of responsible lending laws, setting the scene for a period of outperformance by small cap stocks, according to the chief investment officer of the $6bn boutique wealth management firm Escala Partners.

Tracey McNaughton, a former long-serving UBS executive who joined Escala late last year, said in her latest Escala Partners Perspective podcast series that the firm’s approved product list committee had recently signed off on the inclusion of three new funds, and two were in small caps.

“Our view on small caps has progressively become more constructive as we see the economic recovery continuing and consolidating,” she told clients.

She noted that over the past month small caps had outperformed their large cap rivals in the local market by 14 per cent to 8 per cent.

“Small caps are more sensitive to economic turning points. They are often seen as a leading economic indicator of growth ahead … It makes sense small caps will outperform large caps in the current environment.”

Earlier this year one of the nation’s best-performing fund managers over the past decade, the boutique investment house Smallco, reopened its two flagship funds for the first time in more than two years to raise about $100m.

It is now understood to have closed the funds after raising the capital.

Ms McNaughton said the “two green lights now for Australia” were an expected interest rate cut on Melbourne Cup day next Tuesday and Treasurer Josh Frydenberg’s pledge that fiscal stimulus will not be unwound until the unemployment rate fell back below 6 per cent.

“I think the third comes from the legislation side, with the winding back of responsible lending laws which in our view will stimulate credit growth and underpin the housing market,’’ she said.

Both CBA and Westpac have revised their dire predictions for house price reductions in recent weeks.

Economists have also revised their expectations for the peak in the unemployment rate in the wake of the COVID pandemic from around 10 per cent to below 8 per cent.

But Ms McNaughton said she was wary about the impact of the virus on global markets. The Dow Jones index fell heavily on Monday evening as infection numbers across America continued to soar.

“It really does hinge on the severity and duration of restrictions. It also hinges on the policy response,’’ she said, noting the European Central Bank’s massive stimulus package had stalled, which would impact the European economies hit hardest by a second wave of the virus.

European equities have been moving sideways since the middle of June, even with case numbers being flat and restrictions being very loose.

“They have really run monetary policy as far as they can. They need the stimulus package to come through,’’ Ms McNaughton said, noting Escala had been cautious on European equities for some time.

She said the Reserve Bank’s recent flagging of further quantitative easing in Australian monetary policy would also be designed to weaken the Australian dollar.

“Whether that will be long-lasting or not I don’t know. I am never one to forecast currency — it is a terrible business. But you are up against the Federal Reserve who have the largest balance sheet in the world. If they want a weaker US dollar, they will get it. It would certainly help having a weaker currency. It will stimulate our exports and give us that extra added push. But part of it is just avoiding the Australian dollar strengthening too much,’’ she said.

“It is really a currency play right now. Currencies are in the spotlight in terms of who can weaken their currency the most. Ultimately the US will win that race.”

Escala is backed by Focus Financial Partners, a New York-based partnership of wealth management firms backed by private equity giant KKR, and run by a group of former UBS advisers.