Mike Wilson, chief U.S. equity strategist at Morgan Stanley, said the recent strong performance of small caps is facing technical resistance and lacking long-term fundamental and macro drivers.

The Russell 2000 index rose 6.7% in July, while the S&P 500 index rose just 0.8%, as lower-than-expected CPI data boosted expectations for a Fed rate cut, which typically boosts small caps more than large caps.

In a client note, Mr Wilson and his team said: “While we respect the small-cap enthusiasm or current positioning, we believe the fundamental and macro reasons for a sustained small-cap outperformance are limited.”

In the view of Morgan Stanley strategists, the small-cap rally was partly driven by demand from traders and short covering, but lacked conviction on the earnings side.

The team wrote: “For those looking back to 2016, we note that the current relative outperformance of cyclical small caps is much weaker than then.”

Bank of America strategists cited EPFR Global data last week to show that U.S. small-cap funds recorded $9.9bn of weekly inflows, the second highest on record. The Russell 2000 index hit its highest level in more than two years in that week. In small caps, strategists prefer growth stocks.

They concluded: “With the Fed cutting rates, these stocks should benefit from valuation, but at the same time, they have less of the Fed rate cut story, ie, the pricing power decline.”