Outlook 2018: US small and mid cap equities

Our US small and mid cap team is cautiously optimistic on the outlook for markets in 2018 against a more certain backdrop for economic growth.

7 December 2017

Jenny Jones

Jenny Jones

Head of US Small & Mid Cap/ Equities Small Cap

When we look at the market landscape we begin with valuations which are stretched. The saving grace is the very low level of interest rates, which does allow for higher price-to-earnings ratios. In fact, small cap is attractively valued relative to US Treasuries on an earnings yield basis.

Relative to large cap US stocks, smaller cap companies are fairly valued. We are much more comfortable with valuations versus large caps than we were at the beginning of the year and we are finding more investment ideas in the smaller cap space.

On the corporate front there is good evidence that businesses are relatively optimistic. A leading small business association, the NFIB (National Federation of Independent Business) publishes its Index of Small Business Optimism which has been elevated since President Trump won the US election.

This is a particularly positive indicator given the impact that small businesses have on the US economy: these companies account for 83% of the jobs in the non-farm payrolls (the standard government measure to assess employment conditions). That said, the NFIB Uncertainty Index, although at lower levels than pre-election remains elevated.

Economic growth more certain

It is also worth noting that the yield curve has continued to flatten (ie the difference has narrowed between the yields on short-term and long-term interest rates on US Treasuries).

The market and the Federal Reserve are at odds over the number of rate increases in the coming year. The market is currently expecting an increase in December (2017) and one increase in 2018. The Federal Reserve, on the other hand, is signalling one increase this December and three in 2018.

The US Treasury yield curve is at its flattest level since 2005. While there is much debate on the root reason for the curve flattening our view is that rising rates signal that economic growth is more certain. This should lead to outperformance by cyclical stocks (industrials, materials, consumer discretionary and the financials).

Record-breaking recovery

There is a debate occurring about what stage of the economic cycle we are in. This has been the longest post-war recovery on record with some suggesting there must be an imminent end to the expansion. However, we would assert that recoveries do not die of old age. We would also point out that this recovery, while long, has also been less robust than average. Annual GDP growth has averaged 2.1%, while prior post-war recoveries have seen average annual GDP growth ranging from 3.2% to 7.4%.

Additionally, in our analysis of companies we are not seeing the kind of acceleration in capital expenditure which you would typically expect to see in the late stage of an economic cycle. Such an acceleration can be a sign of overly optimistic demand projections. Addition of capacity is a stair step – following a large increase in the expense base it takes time for demand to catch up with the larger capacity. This interim period can be difficult for companies which have become overextended.

Buffer in falling markets

We are concerned about the potential for inflation. We feel that central banks globally have been underpricing inflation risk. An unexpected rise in inflation would be an event that could create a pullback in the market and perhaps an economic recession.

To date the market has blissfully continued to rise, sidestepping various concerns along the way. This has contributed to the massive inflows to passive investment vehicles such as exchange traded funds (ETFs). ETFs are a cheap way to participate in the market which is very attractive during bull phases.

However, markets eventually stumble and fall and the passive world will not be able to avoid that. As investors become more focused on risk they may turn more readily to those active managers who have the potential to provide a buffer in falling markets.

For the other 2018 outlooks please visit here

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