Global Smaller Companies (GSCT ) believes small-caps are ‘on the cusp’ of a cyclical recovery driven by stubborn inflation, deglobalisation and a ramp up in government fiscal spending.

Columbia Threadneedle’s Nish Patel, who manages the £827m fund, believes the significant discount small-caps trade on versus large-caps suggests a period of strong performance for the former is on the way.

Small-caps have historically outperformed after a fallow period, and despite their 2024 recovery being knocked off course by volatility this year, Patel is confident ‘we are on the cusp of the transition into a new small-cap cycle’.

Although small-caps typically do badly moving into an economic slowdown, they tend to be ‘fairly resilient during the slowdown itself’, helped by the feed through of interest rate cuts and the fact that much of the bad news has already been priced in.

On top of this, a more inflationary environment driven by shifts in deglobalisation and increased spending on fiscal programmes will also boost small-caps and Patel says energy, materials and industrials, will do particularly well in these conditions.

To capture this, he has been putting cash into industrials, which make up just under 30% of the portfolio, and believes the sector will benefit from ‘increased government spending on defence and infrastructure, attempts to reshore and nearshore by multiple developed markets, and automation all mean the outlook for this sector remains positive’.

He is also investing into property services-related companies, including Savills and Jones Lang LaSalle. Although they have struggled as the property market has slowed, he is expecting lower interest rates to result in an increase in transaction volumes being the catalyst for a ‘recovery in earnings’.

Patel is also overweight Japan, which is 11.4% of the portfolio, where he said there is ‘compelling value’ in companies trading below book value, while the market is supported by ‘policy initiative to improve corporate returns’ meaning there is plenty of runway for growth.

European small caps are also catching his eye despite being firmly out of favour just 12 months ago. They now have ‘improving growth prospects’ and make up 10.6% of the fund.

‘This has largely been driven by increased defence and infrastructure spending, initially led by the German government but with the potential to broaden out across the market,’ said Patel.

‘We also maintain selective exposure to emerging markets, including Vietnam, Indonesia, Eastern Europe and Latin America, while remaining cautious on China and North America due to high valuations and possible macroeconomic headwinds.’

To best position the fund for a recovery, despite elevated geopolitical risks and policy uncertainty to contend with, Patel is looking for ‘high quality’ companies with strong balance sheets and pricing power, which are ‘always desirable’ attributes.

‘While the near-term outlook remains mixed, history suggests small caps tend to come back strongly from periods like this. With supportive conditions starting to build, and valuations at historically attractive levels, we are confident the tide is starting to turn for global small caps,’ he said.

The trust is the second-best performer in its five-strong Deutsche Numis Global Smaller Company sector, delivering NAV returns of 5.7% over the past 12 months, and 21% over three years. The shares have risen 5.2% and 23.6%, respectively and is the best performing of its peers over the latter timeframe.