While the natural reaction of US equity investors faced with rising interest rates and the threat of a recession may be to head for the exits, it should be noted that small-cap stocks have historically outperformed the broad S&P 500 index in such episodes.
Contrary to history, it is true that small capitalisation stocks have recently underperformed as recession concerns weigh on investor sentiment in what can be seen as a generally risk-off backdrop for equities (see Exhibit 1).
This view has affected small-cap biotech companies in particular. They are typically in a growth phase requiring capital to fund it and are now being confronted by rising financing costs and a tougher market for funding. Large-cap biotechs are as a rule more insulated from such pressures. As a result, small-cap biotechs have underperformed large caps by 1 500 bp over the last six months.
The perception is also that usually defensive sectors such as staples and utilities are finding it harder to manage and pass on rising transport, raw materials and labour costs. This has caused this typically safe-haven segment to underperform large-cap peers by 1 000bp over the same period.
Too eager to price in a recession
We believe that the US economic environment could be labelled as unstable, but the risk of a recession is low and that, while it is true that the rise in interest rates can weigh on equity valuations, the earnings outlook still looks strong. Recent earnings updates have been encouraging.
Putting the Federal Reserve’s rate rise policy in context, monetary policy is of course being tightened to slow high inflation, but this is possible because the US economy is close to full employment and no longer needs the exceptional monetary support put in place during the lockdowns. The outlook for growth has remained persistently above the long-term average observed before the pandemic, even in the face of factors such as supply chain disruptions and geopolitical turmoil.
Looking at the historical behaviour of equities (S&P 500, sectors, styles, capitalisations) in times when the Fed is raising rates and taking into account our assumptions that over the next 12 months, growth will slow, that inflation will fall from the currently high levels, and that overall financial conditions will remain accommodative, we see the environment as favourable for small caps.
Indeed, the recent contraction in valuations and the shift in sentiment can be seen as good news (for a contrarian, poor news is positive).
Looking to be contrarian
Small caps have been trading as if there is a high potential for a recession and lower earnings growth. We do not think this is the case. With many metrics at or near 10-year lows, we read the signals instead as positive – again from a contrarian perspective. At current levels, we have already surpassed the typical downdraft seen during (actual) recessions.
The 12-month price/earnings ratio fell to 13 by mid-April, which corresponds, disregarding the March 2020 shock, to its lowest since 2011. That could be an attractive entry point at a time when, in our view, many fundamental factors warrant exposure to small caps.
We can expect further market volatility in the near term in the face of the inflation pressures, uncertainty over the path of Fed policy, and a lack of clarity over when the supply chain (globalisation) issues will be resolved or the Ukraine conflict will be resolved. We regard such volatility as an opportunity as we look to find resilient long-term winners at attractive market prices.
Healthcare companies and financials appeal
Sectors we find appealing include healthcare, in particular innovative companies working on drugs for untreated illnesses and unmet clinical needs.
Another area is financials where different drivers apply to small caps than to large caps. Small-cap banks are domestic plays that are more leveraged to rising rates – and eventually wider interest spreads – and less exposed to the vagaries of capital markets and the asset management business. Indeed, earnings estimates in this segment have been moving higher for 2022 and 2023.
The segment is now trading at 10x 2023 earnings, which is below the long-run average of 14x. We believe there is a favourable risk/reward for tech-enabled high-quality small-cap banks.