Small caps poised for a big rebound

Market opinion of U.S. small cap companies has slipped relative to larger cap peers over the last couple of years on fears over the broad economic outlook as the effects of monetary tightening flow through. The stellar performance of some mega cap tech stocks has only exacerbated this disparity. Given this starting point, the outlook for small caps in 2024 could well be quite attractive if the economic picture develops more favorably than anticipated.

One attraction of small cap equities given current geopolitical tensions are their domestic orientation (70-80% versus around 50% for the large caps). In a deglobalizing world, U.S. companies are bringing back manufacturing capabilities, which should benefit industrial GDP over the next decade. Small- and mid-caps form the backbone of the economy and stand to benefit from this trend.

Winners of the future may look different than those of the recent past

In contrast to the last few years, the U.S. is unlikely to go back to a world of zero rates and zero inflation. We are assuming rates and inflation both decline from here and both settle around 2-3%, and the data suggests we are probably past peak rates. The 2024 presidential election will garner lots of media coverage but, in our view, will have minimal effect on markets over the medium term.

Smaller cap companies are typically more highly leveraged than their larger cap peers and have less access to finance. However, a higher-for-longer Federal Reserve rate narrative and a potential U.S. recession have been talked about for some time now, and smaller companies have acted in advance by terming out their debt at lower interest rates, cutting non-essential costs and reducing inventories and headcount. The key will be to focus on those quality companies with strong barriers to entry and pricing power, robust balance sheets and cash generative operations.

Small and mid caps disappointed with low performance in 2023, and market expectations for smaller companies were low going into 2024. But this type of sentiment can often be seen as a great entry point. There are many high-quality smaller cap companies trading on low forward price-earnings ratios. A gentle improvement in top-line revenues could well result in significant operating leverages in earnings, even without a re-rating of the asset class.

Recession odds and AI risks

The U.S. has already experienced a rolling, asynchronous recession over the last few quarters. But the market has remained reasonably robust in the face of increased geopolitical and economic concerns. The consumer has also held up well, with pent-up savings helping cushion against rising inflation and real wage growth starting to come through. The Global Financial Crisis conditioned investors to expect stark economic and market reactions to weak fundamentals. Following this recession cycle, the response may be more muted given how it hasn’t been driven by excess in quite the same way.

AI will change the way we work and live over the next decade and should be an enormous tailwind for productivity. It may be, however, that investors expect these benefits to accrue more quickly than they actually do. The increased use of semiconductors across a wide range of applications—factory automation, the Internet of Things, 5G and electric vehicles—will bear fruit as increased connectivity and artificial intelligence proliferate, but that will take time. Despite the pace, companies that don’t embrace these changes will be left behind. Semiconductors are an important factor of the sectors, such as industrials, we think are poised to grow. Companies that are well-supported from a structural perspective, aided by reshoring, fiscal stimulus and connectivity/data usage trends likely will drive attractive top-line growth for the next decade.