Janvier says: “One of the reasons why smaller companies outperform in periods of rising rates and more normal inflation is because that’s generally a sign that an economy is healthy. It is harder to say what that means when inflation is running at 8 per cent-plus. We shall see.”
The coming recession certainly muddies the waters for small caps. But Eric Papesh, portfolio specialist for US equities at T Rowe Price, says in the current environment they still look attractive.
He says: “Compared to large-cap competitors, small-cap stocks are trading at historically low valuations, fully reflecting investors’ concerns of a coming recession. But at the same time, earnings have held up reasonably well and are likely to improve once the economic outlook stabilises.”
Building a portfolio with small caps
That being the case, how can investors best use US small caps in a portfolio right now?
Diversification is still key, even with a focus on small caps, and in fact a greater focus away from the main indices is looking a better bet right now.
Ben Seager-Scott, head of multi-asset funds at Evelyn Partners, says: “If you’re building a US equity portfolio right now, I suggest you really need to be thinking about the composition.”
For the past few years, he notes, US equity has done very well, but has had a bit of a tailwind from its sectoral composition – that is, lots of technology, not very much energy.
“So if you’re building an active portfolio, you might want to think about getting quite far away from the index composition and look for much greater sectoral and style diversification, as well as looking for great companies,” he adds.
Alec Murray, head of equity client portfolio managers at Amundi US, said US small caps are a good supplement to US large-cap exposure, with some caveats.
“Small caps have much more exposure to cyclical stocks, such as industrials, than large caps. This cyclical sensitivity means small caps typically underperform large caps entering into a recession, but often outperform coming out of a recession,” Murray notes.
The current valuation of small caps relative to large caps is low relative to historical averages, he points out, suggesting small caps are already discounting a recession, at least in part.
“Earnings estimates for small caps may still be too high,” Murray adds, “so we believe a prudent approach is to have only a modest allocation to small caps and add to them on weakness if and when a recession materialises.”
