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Nothing to derail the small cap shift...

Small caps

12 Aug 2024

Key insights:

  • The broadening out theory and the significant valuation gap boost the prospect of rotation of investments into small-cap companies

  • Observations of the market state must be broad-based and not be derived from a single data point

  • Despite potential recession risks, small and mid-cap companies are likely to yield high performance in an early cycle post recession

Charlotte Daughtrey, an equity investment specialist at Federated Hermes, elucidates her views on the current market scenario with a special focus on small caps. She believes that while the recent softening of US data can create fluctuations, it will also prompt the Federal Reserve to cut interest rates, which should favour small caps. The recent dip in equities following unexpected employment data, according to her, is a temporary occurrence as the rotation has a strong potential to be sustained because of the existing significant valuation gap between small and large caps.

Looking at the scenario impacting small caps further, Charlotte asserts that Federal Reserve's move, whether it implies cutting interest rates by 50 basis points or 25, will still help small and mid-cap companies as they are more sensitive to interest rate environments. Meanwhile, she also emphasises the need to look at overall indications to make sure that the economy remains robust. While recognising the role of AI companies in the market, she anticipates potential investors to explore areas beyond the usual, coming into small and mid-cap companies, thereby highlighting their attractive entry point.

Addressing potential risks, Charlotte states that in case the US enters a recession, small and mid-cap companies could face adverse effects. However, she strongly believes that these companies will recover quickly and perform better in an early cycle after the recession. She further acknowledges the role of US politics in creating market uncertainty, but reassures that this volatile phase is temporary and that the economy will dominate politics in terms of its impact on the market.

Full unedited transcript:

0:00

So has the outlook for small caps changed at all in the past week, as the prospects of a soft landing looks to be a little iffy. Following some of that data in the United States. Well, I spoke a little earlier to Charlotte Daughtry, equity investment specialist at Federated Hermes, for an outlook on the smaller end of town.

0:18

Um, that narrative we don't believe has completely fallen apart. I think that the market is experiencing obviously some wobbles, uh, to actually have the softening data that we've seen from the US is a prerequisite for the fed cutting rates, which is what really spurred the market on in July to have the great rotation that we saw into small caps with that moderating inflation print, really bringing in that expectation that the fed were going to cut rates. Now, obviously at the end of the month, we saw the employment numbers that came in at, which caused the market to have some concerns, and we saw volatility spike and we saw markets react to that by equities falling. But no, we do believe that the rotation can be sustained mostly because of the broadening out theory and the significant valuation gap between small caps and large cap, which we do believe is sustainable going forward. I think that's really interesting

1:18

because it's true. It wasn't just those that were looking to get into small caps that were panicking. I mean, the Fear and Greed index went from pretty benign to extreme fear in just a matter of days. So it was sort of everything, baby and the bathwater. So in this thesis, we will see cuts coming through from the Fed in September. Does it matter to you in terms of the small cap narrative, whether it's a 50 basis point cut right away or is 25 enough? If we know, then that we're in this easing cycle?

1:53

I think for the market, they would prefer it to be a 50 basis point cut to sort of calm and quell some of the nerves that they have there, for the fear that the fed is delayed in its actions and is pausing too much. And I think that will give the market a bit more confidence. Whether it's 50 bucks or 50 pips or 25 pips, what isn't necessarily going to matter for us small caps or mid-caps for that matter, because economically those companies are more sensitive to interest rate environments. And so we believe that should continue spurring that on. It's important, though, not to take just one data point and extrapolate that into a trend. We believe looking at broad indications are important and ensuring that the economy remains robust, which in our opinion, it still is. So that alongside the valuation gap and that potential 50 Bips or 25 bits basis parts will be talked so much about how concentrated the market is at that top end, the Mag seven, the AI thematic.

2:52

But arguably some of that money is unlikely to flow into small cap. So it's not just going to be this massive switch into the small to mid cap space, will it?

3:04

No, we don't think it's going to be an enormous switch, but we do think that it is an incredibly attractive entry point for clients to come into and investors to come into small and mid-cap companies. In fact, we've been saying this for quite a long time. The valuation gap. We look at, uh, small and mid-cap companies in comparison to not only their long term history, where they're trading at, uh, below their long term average, but also against large cap. That's an attractive entry point. Now, obviously the AI companies are still good. They are still exciting. They are still going to be in there. But those potential investors that are looking for different areas getting out of that crowded trade, we can see them coming into the smaller mid-caps. And we saw that obviously in July with that great rotation. But I don't think we're going to have it as a complete shift and seesaw effect. But there will be, as we've seen, companies, investors moving out of that large cap trade into small and mid-cap. It also

4:04

also depends on their investment time horizon, of course. And they're you know, there's there's no one size fits all at the best of times. So 50 basis points 25 basis points in September. Not the biggest deal, but what happens if the US does in fact enter a recession because smaller companies arguably can be more impacted?

4:25

Yes. So if the US were to enter a recession, it's hard to avoid a proper recession because it's also understand that not all recessions are created equally. If the US were to enter recession, the outlook for small and mid-cap companies isn't as rosy. But our base case is that we are still potentially going to get maybe a short, shallow technical recession, if not a soft landing, which we still believe is actually constructive for us small and mid-cap companies. And what's important for investors to remember is that actually, in the time after a recession in that early cycle, it's typically those small and mid-cap companies that actually are the best performers. So we don't know what type of recession we're going to have. There's obviously lots of different recessions. We also don't know the length of it. So keeping an allocation to small and mid-cap companies is important because in early cycle, they're the best performers over the one, three and five years. And we saw that

5:25

with the Russell 2500 following the GFC. It was the best performer over small caps. And also S&P 500

5:35

is now Charlotte. Um, you know you've got to mention the elephant in the room is US politics. The X factor perhaps in all of this

5:46

US politics is a very interesting factor. And I think that's actually created more uncertainty in the market, the market like certainty. So at the start of the year, we had two known candidates Biden as the incumbent, Trump as a former president. And the historic decision by Biden to step aside from the election race does leave us with Harris. But what's also happened is that that she's narrowed that gap, which Biden and Trump had. So we we've seen a fading away of that Trump trade. So yes, it is causing volatility. It does cause things to come through. But importantly, investors should remember that it's very short term. And importantly, the economy trumps politics. And what's very important in this side is to understand that actually there's quite a few of their policies that should be supportive for small and mid-cap companies and in fact, US

6:45

equities. Because in the years since the Hoover administration in the 1930s, in every election year, US equities have delivered an average of over 6% annualized return. Now, smaller mid-cap companies don't always go back as far as that. But since 2003, the inception of the Russell 2500 index, the Russell 500 has always beaten the S&P 500 in an election year, so it's important to understand that an election doesn't mean the US equities form, but it will cause volatility and probably a bit more than we were anticipating at the start of this year. But if you have volatility concerns, having an allocation to a portfolio that has a quality bias should help to mitigate and provide some downside protection for investors.