Talking Heads – Contre vents marées : les petites capitalisations américaines

This is an audio transcript of the Talking Heads podcast episode: Standing tall: US small-cap equities 

Daniel Morris: Hello, and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode we will be discussing US small capitalisation equities. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Vincent Nichols, Investment Specialist for US and thematic equities. Welcome, Vincent, thanks for joining me.  

Vincent Nichols: Hi, Daniel, thanks for having me.  

DM: For the large cap indices, this year’s positive returns have depended on a relatively small number of stocks. The broad weighted indices haven’t done all that well. Compared to these benchmarks, small caps have held up better. For the rest of this year and in 2024, what catalysts are you looking for that might generate more small-cap outperformance? 

VN: Small caps should tend to outperform over the long term because of illiquidity, market inefficiencies, lack of coverage, and so on. As we actually haven’t seen that for many years, some investors may be becoming sceptical to that argument. We are not.  

What would really help propel small caps in the near term is something we saw last year that hasn’t materialised yet in 2023 – a major market sell-off. We saw the Russell 2000 index [of small-cap US stocks] fall by some 20% last year. This year, it’s been flat so far, or slightly down. Despite what looks like a good market recovery this year, it’s only really been concentrated in a few stocks. 

If we look back to the inception of the Russell 2000 index in 1984, there have been only four instances of 20% or more drawdowns – last year, and in 1990, 2002 and 2008. Each time, we saw a multi-year recovery period of between three and five years of between 20% and 27% annualised returns after those big drawdown events.  

Generally speaking, that’s a big driver of what may lead to a strong recovery for small caps. We haven’t seen it yet this year, perhaps because of the economy: each of those previous three major drawdowns coincided with a recession, but there’s been no recession yet this year, despite many people predicting it. Those predictions are being kicked down the road to 2024, but we’ll see if that plays out.  

DM: What do you think might drive a recovery in the months and the quarters ahead? 

VN: We are starting to see economic growth accelerate, which has been a surprise for many. I believe many economists and investors believe this monetary tightening cycle inevitably has to lead to a recession. However, what we are seeing in the underlying economic activity is an extremely robust labour market. Job openings, while trending towards normalisation, are still extraordinarily high.  

When you compare that with what we see in terms of workforce participation – particularly with the prime age workforce of people between 25 and 55 years old – it is at its highest in 20 years. There are not enough prime age workers to fill all the job openings, which has led to persistently high wage growth.  

That is a big concern for monetary policy and why the ‘higher for longer’ [interest rates] narrative has set in. But it’s stimulative and supportive of the underlying macroeconomic situation. Such high wage growth is fuelling consumer activity – consumption trends are still resilient.  

We’ve had inorganic government stimulus driving economic growth towards organic income growth and fuelling consumption trends. That has been underappreciated by the market. Many observers have just focused on the ending of stimulus being a major, insurmountable difficulty. Households’  accumulated savings have not been fully exhausted – many observers thought they would have been by now.  

What’s funding this now is nominal income growth, with really strong wage growth exceeding inflation. Inflation has cooled to below the rate of wage growth, so there is real income growth which has helped fuel consumer resilience. High interest rates are unlikely to impact these individual consumers and they even provide a tailwind for the older generation who have more short-term and fixed-income savings. While it’s more difficult to purchase a home, this is not a major headwind for the consumer.  

What could potentially lead to a recession is higher interest rates impeding corporate growth, making companies less inclined to pay their employees and hire more employees. That will eventually flow into the labour market, but it will likely take some time to play out, perhaps longer than people foresee given really strong labour activity.  

A number of cycles are bottoming currently, which isn’t being taken into account by those predicting a recession next year. For example, we’re seeing inventory accumulation being unwound, and for the first time in a long while, new orders are rising while inventories are falling.  

Spending is expected to accelerate next year across all major categories. Data consultant Gartner expect 8% growth in IT spending next year, even for devices, which have been in decline for the last two years. This is similar to the inventory trends. IT was a hot industry for a couple of years. Then as things cooled, we saw a big drawdown. The commentary we’re hearing from those executives looks to be increasingly bullish for a reacceleration in cloud adoption.  

Perhaps most important is the earnings cycle. For the first time in several quarters, it looks like we might see a resumption in earnings growth – not just ‘less-bad-than-feared’ earnings, but potentially positive earnings growth. Earnings expectations have been steadily increasing for a number of quarters now.  

DM: One of the other positive surprises we’ve had this year has been the increase in business investment, which had been lacklustre in the previous quarters. A big catalyst for that was the Inflation Reduction Act, which is having the intended effect of getting businesses to invest more. What is your view? For small caps, could we see a particularly robust capital expenditure cycle? 

VN: Legislation is definitely playing a big part, with the Inflation Reduction Act, the Chips and Science Act, the Infrastructure Investment and Jobs Act. All of these are allocating massive spending to infrastructure investment, so capital expenditure.  

This looks set to be a major stimulus over the next several years, which nicely offsets the reduction and underinvestment in manufacturing capacity, which has been stagnant for maybe a decade and a half, and in some cases in decline.  

What drove that decline was the offshoring trend. For nearly two decades, companies looked to offshore their production to access cheaper labour abroad. This came back into focus during the pandemic when we saw supply chains tighten up as geopolitical tensions bubbled up between countries such as the US and China. There’s now a renewed focus on reshoring supply chains.  

When you pair that with the infrastructure spending, it is going to be a massive tailwind for capital expenditure and for the economy.  

The ‘old-world’ economy – this industrial capex investment – should be a major catalyst for small caps, which have a higher weighting in industrials. They’re more economically sensitive, more cyclically oriented. As it all plays out, it’s going to be a significant factor for small caps in their potential outperformance.  

DM: Vincent, thank you for joining me.  

VN: Thank you for having me.