Global equity markets continued their swift march up in Q3 despite concerns the rally that began in March would prove short lived. Stocks received support throughout the quarter from a growing list of positive economic indicators that fueled talk that a sustainable “synchronized global recovery” was well underway. In-line with past recoveries, the smallest companies outperformed, helping the MSCI World Small Cap Index beat the broader MSCI World Index for the third straight quarter. As a group, global small caps now lead their larger counterparts year to date, with the strongest performance coming from Asian and European companies. Finally, while growth is outperforming year to date, the style gap narrowed in Q3 when value beat growth for the second consecutive quarter.

The majority of economic data released during the quarter came in above expectations. Manufacturing reports were largely positive, a slew of housing reports showed signs of stabilization, and consumer confidence improved overall. While the global recession appears to be nearing an end, the labor market is still weak. The Federal Reserve and the Bank of England each kept their target short-term interest rates steady at historic lows, with the fed funds rate at 0%–0.25% and the Bank Rate sitting at 0.50%. The European Central Bank (ECB) also continued to keep rates at historic lows and unchanged since May at 1.00%. It is widely believed that the ECB and the Bank of England will not begin raising interest rates until next year. Though the economic news flow was generally positive in Q3, negative surprises in U.S. unemployment, consumer confidence, and durable goods orders surfaced at the end of the September, reminding investors that the ride out of the greatest trough since the 1930s would likely be bumpy.

While many approached the Q2 reporting season with a good deal of trepidation, investors seemed to breathe a collective sigh of relief as many companies were able to report better-than-expected results, driven largely by successful cost cutting efforts. Though small cap earnings growth was down substantially year over year, a record number of small cap companies reported positive earnings surprises relative to expectations. Small cap returns were also supported by falling volatility and healthier risk appetites which drove improvements in credit spreads, and strong flows into small cap and international equity funds.

Strong performance among our North American Holdings, and excellent stock selection within the healthcare, financials, and industrials sectors helped the Allianz RCM Global Small Cap Fund outperform over the quarter. Though stock selection was positive across all other regions, relatively weak performance of our Asian holdings proved a headwind to relative performance. Returns were also held back by stock selection within the materials and energy sectors.

Human Genome Sciences was the top active contributor over the quarter. Shares of the biotech company rose sharply on positive trial results for Benlysta, which the company hopes will be the first drug to receive approval for the treatment of systemic lupus in decades. The company also announced that the U.S. government had placed a second order for the anthrax treatment Raxibacumab, which should generate $151 million in revenue over the next three year

Two web-based financial services oriented companies, Moneysupermarket.com Group and Ebix, Inc., were top contributors over the quarter. Moneysupermarket.com’s announcement of a special dividend was construed by many as a sign that the company’s business had stabilized. MoneySupermarket operates a price comparison website for financial products that was heavily impacted by the steep drop-off in loan and mortgage activity. Meanwhile, online insurance exchange provider Ebix’s “torrid” growth rate helped it make #4 on Fortune’s list of the Fastest Growing Tech Companies and #2 on Fortune’s list of the Best Investments in the World.

Though stock selection in Asia was generally weak, one company from the region, Chinese developer of online games Perfect World Co., Ltd., was a top active contributor over the quarter. Continued strong subscriber and revenue growth helped Perfect World beat expectations, propelling the stock to new highs.

Stock selection among Asian equities hurt, and two Chinese companies made the list of top detractors over the quarter. Asian glass manufacturer Xinyi Glass Holdings Ltd. held back returns as weak demand for auto and construction glass weighed on the company’s earnings. Though it is the second best active performer year to date, shares of China Donxiang Group Co., Ltd finished the quarter flat, making it a top relative detractor over Q3. Going forward, we believe the Chinese sports clothier is well positioned for continued growth as the Chinese consumer market expands.

Finally, enterprise software provider Micro Focus International Plc, challenged investors’ confidence with the unexpected and poorly explained departure of its CEO. The abrupt change caused us to lose conviction in the management team, and we subsequently exited the position.

While an official declaration that the recession has ended is still sometime away, we expect modest economic growth over the coming twelve months as the bulk stimulus spending is deployed. Additionally, with the dollar under pressure and the global economy stabilizing, many domestic companies hope that U.S. export growth will facilitate the shift from a margin improvement earnings story to one driven by top-line revenue growth.

Despite a return of economic growth, the consumer is likely to remain wary until employers respond to upticks in demand with meaningful hiring, which should spur income growth. Though consumers may be slow to open their purse strings, companies may well go on a shopping spree. With ample cash sitting on balance sheets, credit markets largely unfrozen, and valuations at low levels, we may see an increase in M&A activity and share repurchases, and investors will be keeping a watchful eye on small cap companies—in the U.S., cash as a percent of market cap for the Russell 2000 Index is nearly double the average since 1988.

Investors also stand ready to put cash to work. Despite the rapid re-investment in equity markets that has occurred since the March lows, record levels of cash remain on the sidelines. While more than $7billion has already returned to small cap funds year to date, a staggering $3.4 trillion remains parked in money market funds. If risk appetites continue to improve, we expect continued flows into small cap funds will provide support for share prices.

Finally, we are encouraged that the low-quality rally may be near an end. Markets should shift away from favoring the stocks that had been beaten back most during the equity sell-off, and begin to reward higher-quality companies which should be fundamentally best positioned to participate in the recovery—the very companies we favor.