Abrdn Small Cap Funds Show Divergent Performance in Q2 2024

abrdn International Small Cap Fund Q2 2024 Commentary

Against this backdrop, corporate first quarter results have generally exceeded expectations, particularly from those companies exposed to artificial intelligence. The abrdn International Small Cap Fund (Institutional Class shares, net of fees) returned 2.82% for the second quarter, outperforming the 0.66% return of its benchmark, the MSCI AC World ex USA Small Cap Net Index. The main positive contributors to the Fund's relative performance were the information technology and consumer discretionary sectors, due to stock selection in both cases. Among the main contributors to performance, ASICS Corporation (OTCPK:ASCCF)(OTCPK:ASCCY), the Japanese sports apparel company, continued to execute on its strategy, leading to stellar first-quarter results. The company has also been promoted to the mid-cap benchmark, which has opened up the stock to a new set of buyers, and is a beneficiary of the weaker yen. FPT Corporation, the Vietnamese provider of information technology [IT] services, telecommunications, and higher education, performed well after it announced a new partnership with NVIDIA (NVDA) to provide GPU-as-a-Service (Graphics Processing Unit resources delivered as a cloud service). FPT continues to see strong demand from its Japanese clients in IT services, more than offsetting macroeconomic pressures in its telecommunications business. Nova Measuring Instruments, the manufacturer of equipment for measuring microscopic parameters of semiconductors, released another strong set of results and upgraded its guidance. The company continues to gain good traction for its high-end products. In contrast, communication services and financials were the largest detractors from the Fund's relative performance, due to stock selection in both cases and, to a lesser degree, being overweight the former sector. In terms of individual stock detractors, YouGov (OTCPK:YUGVF), the UK-based provider of panel-based market research, opinion data and analytics tools, disappointed investors after an unscheduled trading update. Demand is likely to be below management expectations, and as the company continues to invest in the business, margins will also be under pressure. Interparfums, the manufacturer of perfumes for major brands, underperformed, with indications of weakness in the luxury goods sector. In Mexico, the Claudia Sheinbaum presidency was taken negatively by investors. As a result, Regional, the Mexican bank, fell along with the local market. During the quarter, we initiated holdings in three companies. We introduced a position in Japan Elevator Service (JES), the Japanese independent elevator maintenance provider. In Japan, building managers often switch to independent companies after four to five years of maintenance contracts with elevator manufacturers, as pricing is about 30-50% lower. We think JES will continue to benefit from this trend. Additionally, we initiated a holding in UK-listed Hill & Smith (OTCPK:HSHPF), which has 30 companies operating from 57 sites in five countries. These companies are supported by a head office team that offers support and leadership in areas including capital allocation, mergers and acquisitions, and health and safety. The business is split into three divisions: 1) Roads & Security; 2) Engineered Solutions; and 3) Galvanising Services. The business is witnessing strong demand from the U.S. infrastructure bill, which has bipartisan agreement. The U.S. represents around 75% of the group's profit. We introduced a holding in Rational (OTCPK:RTLLF), the German manufacturer of professional cookers. With no new competitor technologies to compete with its combi-steam product, the growth story from increased market penetration remains robust. During the quarter, we sold our positions in three companies. We sold Daiseki (OTCPK:DSKIF) as the company's strength lies in processing waste acids, alkaloids, and other waste liquids within Japan. Japanese industrial production continues to be weak, possibly affected by suspended production at some major car manufacturers. This does not aid Daiseki's volumes; hence, management's guidance was below expectations. We disposed of our position in CVS Group (CVS), given unknowns from the Competition and Markets Authority's investigation into veterinary prices in the UK. Lastly, we sold our holding in BE Semiconductor Industries (OTC:BESIY) due to a rich valuation. Global equity markets ended higher over the quarter. Given continued disinflation in recent months, the ECB, the Bank of Canada, and the Swiss National Bank have all started cutting interest rates. Moreover, investors are factoring in further interest-rate cuts in most regions later in 2024. However, with inflationary pressures still present, the world's major central banks have maintained a cautious stance on monetary policy. As a result, any additional easing is now expected to occur later in the year than previously forecast. Meanwhile, robust economic data, particularly in the U.S., has raised hopes for a 'soft landing'. Against this backdrop, corporate first-quarter results have generally exceeded expectations, particularly from those companies exposed to AI. However, investors continued to be concerned about the outlook for the Chinese economy, especially the country's property sector, and the implications for global economic growth. The ongoing wars in Ukraine and the Middle East remain other key risks. U.S. equities ended higher. Despite still-elevated bond yields, large technology companies, led by NVIDIA, fared especially well as they benefited from their exposure to the fast-growing area of AI. U.S. annualized GDP grew by 1.3% in the first quarter of 2024, compared with a growth rate of 3.4% in the previous three months. Inflationary pressures continued to ease over the quarter after a succession of interest-rate increases from the Federal Reserve (Fed) since early 2022. In particular, the central bank's favored measure of inflation, the core Personal Consumptions Expenditures Price Index, fell from an annual rate of 2.8% in April to 2.6% in May, as expected, but remained above the 2% target. The Fed kept the target range for the fed funds rate at 5.25-5.50% over the period but has signaled just one rate cut over the remainder of 2024 (having previously flagged three), with more easing to come in 2025 and 2026. European equities rose over the period. Annual GDP in the eurozone grew by 0.4% in the first quarter of 2024, an improvement from 0.2% in the last three months of 2023. According to initial estimates, annual consumer price inflation fell from 2.6% in May to 2.5% in June, as expected, but the core rate remained at a higher-than-forecast 2.9%. In response to continued disinflation in recent months, the ECB cut its main refinancing operations rate by 0.25% to 4.25% at its June meeting. Meanwhile, French President Emmanuel Macron called for a snap general election after his centrist alliance suffered a shock defeat to the far-right National Rally in the European Parliament elections. The resulting political uncertainty, coupled with concerns about France's future fiscal position and the stability of the EU, led to a sharp sell-off in French equities and government bonds. UK equities ended higher but underperformed most other regional indices. Prime Minister Rishi Sunak called a snap general election for July 4, looking to take advantage of stronger economic data. Annual GDP grew by just 0.2% in the first quarter of 2024, although the UK economy had contracted by 0.2% in the fourth quarter of 2023. Annual inflation fell from 2.3% in April to 2.0% in May, as expected, returning to the Bank of England (BoE)'s target. Moreover, annual core inflation was in line with expectations, falling from 3.9% to 3.5% over the same time frame. The BoE maintained its Bank Rate at a 15-year high of 5.25% over the quarter, but there are indications that it may soon begin to ease its policy. In the Asia Pacific region, stocks in Australia underperformed due to continued concerns about the Chinese economy despite further stimulus measures in the country. The Reserve Bank of Australia kept its cash rate at 4.35% over the quarter. Japanese equities ended higher. Annual GDP contracted by 0.2% in the first quarter of 2024, having grown by 1.2% in the last three months of 2023. Annual core inflation of 2.5% in May remained above the Bank of Japan (BoJ)'s 2% target. The BoJ kept its key short-term interest rate at around 0-0.1% over the quarter. However, the central bank has signaled the possibility of another rate hike at its next meeting in July (following the increase in March) and will also be looking to start reducing bond purchases then. This potential shift comes as the BoJ's ongoing accommodative monetary policy stance has led to further yen weakness, triggering central-bank intervention. In the BoJ's latest quarterly Tankan survey, the sentiment index for large manufacturers improved from +11 to +13, but that for large non-manufacturers edged down from +34 to +33. Emerging markets ended higher, despite a stronger U.S. dollar, given investors' increased optimism about the global growth outlook as falling annual inflation rates led to central banks considering future interest-rate cuts. Chinese equities languished despite the Chinese authorities announcing fresh stimulus measures to support the economy. The yuan further depreciated due to continued worries about the country's uncertain economic outlook and its indebted property sector. Indian equities outperformed, helped by Prime Minister Narendra Modi's pro-business reforms. The country's first-quarter GDP rose by a stronger-than-expected 7.8% year-on-year, and the central bank kept its benchmark rate at 6.5%. Stocks in Taiwan were supported by the country's relatively high weighting to the buoyant technology sector. Brazilian equities ended lower over the period, given investor concerns about the country's fiscal position under left-leaning President Lula da Silva and the fact that China is Brazil's main export market. The Central Bank of Brazil further reduced its Selic rate from 10.75% to 10.50% over the quarter after 12 consecutive rate hikes since March 2021 had led to a marked reduction in annual inflation. Meanwhile, Turkey's central bank kept interest rates unchanged at 50% during the period as annual inflation rose above 75% and the lira continued to depreciate. Nonetheless, Turkish equities ended notably higher, driven by strong economic growth, robust corporate earnings, and improved investor sentiment after recent policy changes. An important barometer for the near-term direction will be second-quarter earnings results. To sustain the current market uptrend, investors need to see further earnings surprises. Note, however, that large-cap valuations are consistent with late-cycle demand, whereas earnings expectations of low-to-mid-teens percentage growth are typical of early in the cycle; in other words, both valuations and earnings forecasts appear high. Small-cap valuations, in contrast, are more measured and at a significant discount to those among large caps. Concentration in the small-cap benchmark is also vastly different from the large-cap equivalent, with materially lower potential for overheld positions being unwound. As well as these points of note, it is worth flagging two additional areas of uncertainty. The first is politics. The Mexican and Indian elections showed that polls are not always accurate, and as we await the next round of the French election, we also look toward the UK and US elections, later in the year, where there is scope for regime change. Not uncoincidentally, the issue of tariffs has resurfaced once again, raising geopolitical tensions and skewing market dynamics. The second area to watch is a rapid reversal in currency markets. Here, the currency that stands out is the Japanese yen. The yen is now at a 37-and-a-half-year low versus the US dollar and at a substantial low compared to the euro. Prime Minister Fumio Kishida is under considerable pressure to act. The Japanese currency has a wide trading window and could move sharply when the countries' central banks deliver opposing policies. For the reasons above, we prefer to stay in high-quality, small-cap equities with resilient and visible earnings streams and the propensity to deliver stable growth.

abrdn U.S. Small Cap Equity Fund Q2 2024 Commentary

The Fund fell but outperformed its benchmark, the Russell 2000 Index, largely due to stock selection. The abrdn U.S. Small Cap Equity Fund (Institutional Class shares, net of fees) returned -1.76% for the second quarter of 2024, outperforming the -3.28% return of its benchmark, the Russell 2000 Index. Sector wise, consumer discretionary, information technology [IT], and financials were the largest outperforming sectors for the Fund. Conversely, the industrials, materials, and energy sectors detracted from performance. At the stock level, Boot Barn Holdings' (BOOT) shares outperformed and added to returns after data points showed a consistent improvement in trends. Brinker International also performed strongly as the company raised guidance due to traffic trends continuing to lead the industry. Meanwhile, Onto Innovation (ONTO) was positive as its shares outperformed after customer TSMC (TSM) increased its outlook for artificial intelligence-related revenues, which was followed up by a strong earnings report from Onto. Conversely, Atkore (ATKR) detracted from performance. Its shares underperformed as destocking and a slower-than-expected production ramp resulted in a guidance cut. H&E Equipment Services' (HEES) shares underperformed after the company's results pointed to weakened demand in construction markets. Meanwhile, Five9 (FIVN) was unfavorable as its shares were weak as investors grew increasingly concerned about the company's ability to accelerate sales in the back half of the year, particularly after Microsoft (MSFT) announced plans to provide an expanded contact center solution. In terms of activity, we initiated Corcept Therapeutics (CORT), a commercial-stage biopharmaceutical company specializing in drugs to treat Cushing's syndrome and other cortisol-related diseases. We believe the company's next-generation drug could allow for increased market penetration. We also initiated Atmus Filtration Technologies (ATMU), a manufacturer of filtration systems for heavy-duty trucks and machines. We believe the company's strength in research and development, along with its expansive product portfolio, could allow it to capitalize on rising air standards. Lastly, we initiated JFrog (FROG), a leader in binary management, which is a core technology in software deployment. We believe this leading position could allow the company to benefit from growth in software builds. Additionally, JFrog's continued shift from a single-solution to a platform provider could support growth over the long term. Conversely, we sold Perficient (PRFT), an IT consulting company, after it agreed to an acquisition by a private firm. Total Returns (as of 06/30/24) U.S. small caps ended lower over the quarter and underperformed the broader U.S. equities asset class. The U.S. economy, particularly the labor market, has continued to prove resilient and robust despite slowing. Consequently, annual consumer price inflation was higher than expected over the first three months of this year before meeting expectations in April, although it came in lower than forecast in May. Meanwhile, heightened tensions in the Middle East have brought additional inflationary risks due to the potential effect on crude supplies and shipping costs. At its June meeting, the Fed kept the target range for its fed funds rate at a 23-year high of 5.25-5.50%, marking the seventh consecutive time it has left rates unchanged. The latest 'dot plot' from the Fed's committee members forecasted just one rate cut in 2024, whereas three had been predicted back in March, with further easing likely in 2025 and 2026. However, after steadily falling over the course of last year, the Fed's targeted inflation measure-the annual core Personal Consumption Expenditures (PCE) Price Index-has only slightly declined in the first five months of 2024. Against this backdrop, Fed Chair Jerome Powell reiterated at the June meeting that the central bank requires more evidence of core PCE inflation sustainably moving towards the 2% target before considering policy easing. Therefore, the Fed aims to maintain a restrictive policy stance, proceeding cautiously with a data-dependent approach as it seeks greater clarity on underlying economic trends. As a result, investors now anticipate only one or two rate cuts in 2024, starting in the autumn at the earliest. Previously, investors had been factoring in as many as six or seven cuts from June onwards. Moreover, some Fed officials are in favor of further tightening to keep stubborn inflation at bay. However, Fed Chair Jerome Powell has stated that the central bank's next move is unlikely to be a rate hike, which has reassured investors somewhat. Otherwise, U.S. corporates' first-quarter reporting season has turned out to be better than expected. In particular, certain technology companies, including several in the semiconductor sector, have continued to outperform consensus expectations given their strong growth prospects in AI. However, the substantial costs of investing in this field remain an investor concern. Small caps (as measured by the Russell 2000 Index) fell 3.3% over the quarter and underperformed large caps (with the Russell 1000 Index up 3.6%). Sector returns within the small-cap market were mostly negative over the quarter. In terms of the style subsectors of the Russell 2000 Index, value fell 3.6% while growth declined 2.9%. Within the U.S. small-cap index, consumer staples notably outperformed the index, as potential rate cuts were expected to support U.S. consumer spending and the broader economy. Utilities outperformed on expectations of potential interest rate cuts later in the year, which would reduce their high debt servicing costs. Additionally, the sector benefited from increased electricity demand driven by the AI boom. Communication services also outperformed the index over the quarter given the sector's defensive attributes amid the broader weakness in U.S. small caps. Financials was another outperformer as the sector benefited from lower interest-rate expectations as credit quality should improve due to lower borrowing costs. The energy, IT, and real estate sectors all performed broadly in line with the index over the quarter. In contrast, consumer discretionary and industrials lagged the index given these sectors' gearing to softer U.S. economic data. Healthcare was also weak, as the prospect of interest rates staying higher for longer weighed on growth companies in the sector. Materials was another underperformer because of various headwinds, including a stronger U.S. dollar and concerns about the outlook for the Chinese economy. U.S. economic growth has been resilient, but the pace has moderated as a result of slower consumer spending and subdued investments driven by higher interest rates. In line with this, inflation has also slowed in recent months, which we expect to continue with ongoing easing in the labor market, wage growth, and housing inflation. Despite these signs of cooling inflation, the Fed remains cautious in its approach to cutting rates, signaling only one cut for this year. Against this backdrop, the outlook for small-cap stocks remains positive for several reasons. Firstly, small-cap stocks trade at a significant discount compared to their larger counterparts. We expect a broadening out of the market away from the 'Magnificent Seven' as the same fundamental tailwinds driving these stocks higher flows through to the more economically sensitive small-cap companies. Moreover, corporate balance sheets are flush with cash, often triggering merger and acquisition activity, with smaller companies historically benefiting as a result. Finally, an elevated rate environment creates structural advantages for higher-quality companies, a core tenet of the strategy's investment process. These companies are better equipped to handle higher interest rates relative to their lower-quality peers. Altogether, this combination of factors supports our positive outlook for the small-cap strategy.