The backdrop for investors in US equity continues to be skewed towards the positive. Recent US economic reports have been encouraging: real gross domestic product (GDP) increased by 4.2% in the second quarter of 2018, according to the second estimate by the Bureau of Economic Analysis. In addition, the ISM Manufacturing Survey is reporting a reading showing robust expansion and the latest jobs report was strong, with the unemployment rate at the lowest level since 1969.
Meanwhile, we have experienced strong realised earnings growth this year along with healthy expectations for future growth. The continued strength of the US economy, partially driven by tax cuts and fiscal spending, has meant that investor and business confidence has remained robust.
Still volatile in a solid environment?
Why then have stock markets been so choppy? While it is true that the S&P 500 index has returned 9.5% so far this year through the end of August, concerns around the consequences of a potential trade war for the economy and listed companies have been weighing on stock prices.
We believe protectionism could present a significant threat to stocks. Trade barriers typically raise prices for consumers and interrupt the free-flow of producer goods and services. Investors are worried and stock prices have been volatile as a result.
Clearly, a significant escalation could quickly undermine currently positive investor and business sentiment. The US has taken an aggressive approach to trade issues, particularly with China, and every new tariff has immediately led to a proportionate Chinese retaliation. Under normal circumstances, diverse sources of revenue and earnings are viewed as a positive, but companies that rely on exports or have a large portion of their revenues coming from outside the US face pressures in this environment.
Exhibit 1: Domestic nature of small caps
Source: FactSet, as at 31/08/2018
Let us state clearly that in our assessment, an all-out trade war will be avoided and an agreement will be reached to avoid major damage to the global economy. Given the risks, however, we think that US companies with higher levels of exposure to domestic rather than international sources of revenues look more attractive and are better insulated from trade issues. This means small-cap stocks.
Risks favour small caps…
We are not alone in this view as small caps have done well. The segment has outperformed large caps for five of the past six months. This corresponds to the period from March when the possibility of a trade war began to gain attention. Small caps’ outperformance over large caps since February is the strongest since the global financial crisis (+15.6% vs + 7.6%). Essentially, we believe small-cap stocks have emerged as a relatively safe bet in this scenario.
Investors have sought out smaller companies for several reasons. First, they are likely to remain relatively insulated from the economic impact of a trade war. Second, they are expected to benefit appreciably from the recent tax cuts. Small caps have also experienced a boost from a local corporate tax cut, given the domestic nature of their revenue and earnings. We would argue the consumer tax cut has also helped since small caps tend to be more sensitive to local economic trends and demand. This is why we believe it makes sense to invest in selected small-cap stocks at this point.
…also at a sector level
In comparing the recent results of small caps versus large caps, it is instructive to look through at sector results as well. The bulk of the outperformance was driven by two sectors – financials and health care. Small-cap financials have risen by 10.5% from March through August, while the S&P financials sector as a whole has fallen by 1.3%. Small-cap health care stocks have outperformed by a similar amount (12%). While there are several catalysts for these two sectors (recent deregulation, hearty earnings growth and increased M&A activity), it should not be ignored that they are both very domestically oriented sectors. This can be seen in the chart below.
Exhibit 2: Percentage of international sales (by sector)
Source: FactSet, as at 31/08/2018
Although small caps do generally have a lower percentage of foreign sales (20% versus 40% for large caps), we know that their margins are also much lower than those of large caps. This means that additional tariff-related costs have a much stronger impact.
The current situation harkens back to the risk-on environment which followed the 2016 presidential election. At that time, small-cap shares experienced a tremendous upsurge, buoyed by speculation over tax cuts, the Republican pro-growth agenda and protectionist measures. As a result, between Election Day and the end of 2016, the small-cap Russell 2000 gained 14%, easily outperforming the large-cap S&P 500’s 4.6% increase.
During 2017, however, gains for small caps faded as doubts arose over the Trump administration’s ability to implement the president’s electoral promises. The US dollar weakened, which helped boost earnings for companies with high levels of exports (i.e., large caps). But the reverse has been true this year as the domestic nature of small-cap companies has been a tailwind.
Scope for continued optimism
We remain upbeat on small caps following the broad-based strength in earnings reports and continued expectations for earnings growth acceleration into the second half. We also view valuations as reasonable relative to the current interest-rate environment. Assuming the geopolitical backdrop does not worsen and derail economic expansion, we expect the US Federal Reserve to continue to raise policy rates slowly, bond yields to climb and the US dollar to firm modestly over the coming months.
To emphasise the point, underlying macroeconomic conditions are sufficiently robust in our view so as to justify the current small-cap tailwind. As consumers and companies continue to feel the positive effects of economic expansion, the fundamentals are likely to keep improving as well, which should also buoy small-cap stocks.
In our judgement, the fundamentals suggest this equity bull market will continue. While a recession would likely end the bull run, we see little evidence of a deteriorating environment. To the contrary, economic growth is accelerating. Meanwhile, small caps are trading at a discount to their long-term relationship with large caps.