US small caps have had a tough year and, despite their recent rally, they are anything but flavour of the month.
From September into October, riskier assets were sold off and treasuries rallied, as more gloom descended on the eurozone, even casting a pall over Germany. China continued to drag its feet and fears grew that deflation could become globalised. Markets remain volatile in the face of a growing list of anxieties (terrorism, Ebola, policy errors in Europe), but a secular equity bull market is still intact. My view is that the hit to the US economy due to recession in Europe will be minimal unless the banking stress test results reveal a bigger financial problem in the eurozone. In the face of uncertainty elsewhere in the world, US dollar assets are not a bad place to be invested.
Given markets’ pervading obsession with monetary policy, there are real concerns that the end of the Federal Reserve’s quantitative easing could herald a further sell-off. That said, central banks are now striking a more dovish note, lending support for bonds.
What should one do? My view is that the US is going to continue to grow and that inflation in the US has bottomed out. Producer price indices show inflation over a rolling 12-month period to be stable. Employment figures are strong and trending well, commodity prices have fallen and the dollar has strengthened, giving the US consumer more disposable income. Looking to 2015, there are signs that fiscal drag from government austerity measures will reduce, giving further support to the US growth engine.
The US has steadied its course, and is perhaps the one major economy that has genuinely come to terms with its credit issues, and is ploughing ahead. The US is tackling its debt situation and, yes, the economy is still leveraged, but there is a sense that normal service is resuming following the 2008 crisis. Three per cent growth is expected this year, and while next year growth may be a little less, it is still expected to be considerably ahead of expectations for the eurozone.
In spite of some disappointing macro data (for example, the recent fall in retail sales), I am optimistic regarding US economic growth.
In the competition for the least ugly currency, the US dollar comes out on top. Despite the recent rally in treasuries, I am of the view that the Fed will most likely raise rates some time in 2015. In this situation, investing in treasuries does not offer good return prospects. US large caps rely more heavily on exports than their smaller counterparts – about 35 per cent of S&P 500 revenues are generated overseas – and are therefore more likely to suffer from a stronger dollar.
This brings us back to opportunities in domestically focused US small caps.
So, what about price? Despite a bad year, US small caps are still trading at a premium on an historic basis, but they are trading in line with their long-term average, relative to the S&P 500.
Small caps have outperformed large caps by 10 per cent since the start of 2012 to March this year, but since then they have given up most of these gains. These developments have made US small caps look better value.
US small caps do not appear cheap at present, and analysts’ estimates anticipate 18 per cent earnings growth in 2015. In comparison, earnings growth for large caps is 12 per cent. (Source: Institutional Brokers’ Estimate System median consensus). This is a big ask for earnings for small caps, and the current earnings season will be important as a guide to future prospects.
Q3 earnings have been hotly anticipated and attention is shifting towards ways of capitalising on the promising US growth outlook. Earnings for the Russell 2000 are currently at an all-time high and sales are close to their 2013 peak.
Small caps have the potential to be re-rated given they are more closely linked to recovery in the domestic economy. The increase in corporate activity is also supportive for small cap companies. The risks of leveraged balance sheets are not yet a concern, as cash balances remain healthy.
We may or may not see a fixed-income rotation into stocks, but it does seem that options for long-only investors are quite limited in the current market. Eurozone travails are well-documented and the European Central Bank has a major challenge on its hands. Previously, the ECB’s long-term refinancing operation seemed to save the day, but will it be able to pull another rabbit from the hat? In any case, it is clear that the November central bank meetings between the ECB, Federal Reserve and the Bank of England will be particularly important.
Further afield, emerging markets have recently struggled with structural problems, and the end of QE certainly will not help their immediate outlook. Falling commodity prices are another major concern for emerging markets. Currency weakness and a lack of inflation in these markets could provide some monetary flexibility; however, it is unclear whether this alone will be enough to change the outlook for emerging market assets.
In the UK, we have an unpredictable election in the next seven months, which could increase volatility in sterling. The weakness of sterling is an advantage for the FTSE 100, which has a higher proportion of overseas earnings than the US. However, given the proximity of the UK to the eurozone, some of its troubles could easily spill into the UK economy. In spite of an attractive equity valuation, I prefer the US small cap market to that of the UK at present.
In my view, investors would be well-advised to use the 2014 underperformance in US small caps to get exposure to US domestic growth, which remains one bright spot in the global economy. Employment, confidence and spending power are improving, and the US consumer base is fundamentally the most valuable in the world. The US has made good inroads on its debt situation, and smaller companies are not nearly as expensive as they were in March, for example, or indeed for most of the last year. The asset class is certainly one, I think, that long-only investors should be considering as this earnings season develops.
There are risks to this investment strategy: the lack of inflation and pullback in the US economy due to current slowdown in other major economies. As highlighted earlier in this article, the asset class is, at best, priced at fair value, therefore any pullback may adversely affect it. There are other cheaper assets (for example, Russian equity, Chinese banks), but the lack of a catalyst to unlock their value makes US small caps a more attractive risk-adjusted return investment.
Meena Lakshmanan is a partner and head of investment solutions at Vestra Wealth
Key points
US small caps are not flavour of the month – yet.
There are real concerns that the end of Fed QE could herald a further sell-off.
In the UK, we have an unpredictable election in the next seven months which could increase volatility in sterling.
