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With Central Banks in bifurcation mode, the number of positive performance contributors to the future market performance is expected to be broader. Therefore, it is time to consider small-cap stocks.
Key Takeaways
Over the past years, money has flowed out of the so-called Magnificent 7 tech stocks and toward other, long-duration asset, value-oriented, and economically sensitive “cyclical” equities such as financials and industrials. As inflation cools and growth is robust, one can consider the FED to have achieved “a no landing”.
Given this favorable backdrop, investors are advised to switch gears and embrace small-capitalization equities (companies with market value between $250 million and $2 billion). After underperforming for most of the past three years, these stocks look relatively cheap and, in theory, should benefit most from lower borrowing costs, given their greater reliance on external financing and floating-rate debt.
In recent weeks, small-caps cyclicals traded well as most economic data was better than expected. As small caps bear greater average risk, it’s worth noting that investors should stay up the quality curve within the cyclical space. At the sector level, Financials have been the best-performing in the S&P 500 for quite some time now. Given that institutional investors remain under-exposed to financials, the sector performance can probably surprise to the upside further.
In addition to better soft economic data, other factors affect pro-cyclical stocks. We are focused on two, in particular: 1) The US election and 2) global liquidity.
As for now, primary estimates suggest that swing States favor a Trump administration and a split Congress which in turn would support a pro-cyclical bias with small caps keeping pace with large caps. If so and by extension, the trade war between China and the US would escalate by one more notch impacting consumer stocks further.
A further remarkable observation is that market participants have reduced their exposure to the US resulting in higher interest rates and a stronger US Dollar. Consequently, this trend could continue and generate a liquidity event post-election and into 2025.
Whoever will be elected and heading the administration in Washington, tariff risks and managing immigration will impact the US business conduct going forward. In 2016 Trump's pro-business approach led to the largest 3-month positive impact on small business confidence in the past 40 years. It also translated into a spike in individual investor sentiment, a similar development can be observed already now.
In the contrary case, a Harris win could lead to some mean reversion of overall equity market performance and US leadership could take a short-term hit. This in turn would result in bond prices rallying and top US quality stocks doing better versus growth. Even in the case of a Trump win, markets are vulnerable to “a sell the news” phenomenon as much of the upside potential is already reflected in the present valuations.
Portfolio Moves to Consider
We note that this present configuration is not a typical economic cycle, and small caps are no longer the ultra-risky asset class they used to be. We see notable skews in the underlying data that create nuanced opportunities along secular growth trends.
Considering all of these issues, we think dynamic and long-term investors should continue to consider small caps while more conservative investors should continue to add exposure to large-cap value and mid-cap growth stocks, pursuing an active approach in line with an uneven no-landing.
Knowledge is power.
