As the US economic recovery continues, small businesses, the engine of the national economy, appear well positioned to benefit.
The rebound in investor confidence after the most volatile period for global equity markets since the global financial crisis has been extremely encouraging. What’s more, the rally in US equities was not limited to large companies, but extended across the entire market capitalization scale.
Yields for US smaller companies dominated the broader market from late 2020 to early 2021, before retreating through the second and third quarters and then accelerating again more recently. Given this positive development, some investors are asking the following question: what will the evolution of US small caps look like in the short term?
First, it’s interesting to note that US small businesses performed significantly worse than large businesses in the decade leading up to the onset of the coronavirus pandemic. Since the pandemic-induced market trough (March 15, 2020), small US companies have significantly outperformed large companies: the Russell 2500 index has gained 128.7%, compared to 103.8% for the S&P 500 index As for the recent weakening in US small business performance, this is more likely just a pause for breath, rather than a more fundamental sign.
Investors looking for tomorrow’s winners should include smaller capitalization companies in their universe.
In 2022, we expect the environment to remain largely supportive of small US businesses. Clearly, the returns generated from the pandemic-related lows will not be repeated, but as the U.S. economic recovery continues to grow and expand, investors looking for tomorrow’s winners should include companies at smallest capitalization in their universe.
Potential Factors for US Small Cap Success
While we must remain vigilant, several other factors could continue to support the positive trend in small cap performance in 2022. Many have indeed found success as such, thanks to some important pandemic-related opportunities:
- First beneficiaries of the recovery
The US economic recovery should continue to benefit small US businesses, which tend to be more sensitive to fluctuations in the economy. An excellent employment report in October – the US economy created 531,000 jobs – reinforces the image of a US economy regaining strength after a lackluster summer. Meanwhile, Congress has finally approved a $1.2 trillion infrastructure bill after months of debate.
- Drivers of the national economy
In 2019, the Small Business Administration reported that small businesses employed 47.3% of the private workforce, making small businesses the real engine of the US economy. Small caps tend to do well when economies recover, and with the US economy growing at an above-average rate, this represents a potentially big boost for small companies in the year ahead.
- Inflation less worrying
While the strong recovery of the US economy was very encouraging, the resulting rise in inflation was less encouraging. Annual consumer price index inflation jumped to 6.2% last October, the highest rise in 30 years. Whether it’s a transitory peak or the start of a potentially longer-term trend, small caps have historically done relatively well in times of high inflation.
- Sensitivity to interest rates
Rising interest rates are worrying many investors, who fear that higher yields will come with falling stock prices across the market cap spectrum. Historically, however, small caps and rising interest rates have enjoyed a reasonably harmonious relationship. Interest rates and the shape of the yield curve have impacted the performance of small cap stocks over time. Small caps are also more exposed to rate-sensitive financial stocks than large caps.
- Diversified and understudied market
The 2,500 US mid- and small-cap companies that make up the Russell 2500 Index offer a broad and diverse range of companies to invest in – from established industry leaders to new and innovative micro-caps. The larger share of the market tends to be more concentrated and clearly skewed towards a few major sectors. In addition, small and medium-sized companies often have little follow-up from investors, which creates good opportunities for active and research-oriented breeders, who can thus discover hidden gems.
Encouraging business results
US small business results have been encouraging over the past 18 months, supporting strong investment returns.
While further positive returns are expected in 2022 for US small businesses, gains are expected to be more modest, relative to the past 12-18 months. Going forward, the market is approaching a point where fundamental quality is likely to matter more and where the increasing differentiation of small company earnings will have a significant impact on returns.
The economic recovery will continue for at least the next 12 to 18 months, not without challenges.
The pandemic has had the effect of spotlighting companies with quality business models, effectively forcing them to prove their sustainability. Quality companies have been able to strengthen their competitive position and are now poised to emerge with greater profits and cash flow when the economy reopens. Many of the defensive measures companies have taken to preserve cash have turned into permanently reduced cost structures, such as real estate downsizing, due to the shift to full-time or part-time work-from-home models. These actions, combined with proactive measures taken by some companies, as their smaller or more heavily indebted competitors focused on survival, have strengthened their advantages, expanded their markets and increased their long-term profits from pre-pandemic levels. .
A final word for 2022
The economic recovery will continue in our view for at least the next 12 to 18 months, not without challenges. Markets are expected to remain highly sensitive to news from economic indicators and the lingering effects of the pandemic. While small-cap returns will slow from their recent pace, we also believe that an ongoing economic recovery, along with improving macro indicators, will produce a favorable market environment for small-cap performance.
As always, it is important to remain vigilant. The resurgence of coronavirus cases could easily dampen economic recovery and market confidence. We would like to see improved data in the consumer sectors, such as restaurants and hotels, as well as data for retail sales and the PMI. From a sector perspective, we favor certain cyclically prone growth sectors, such as industrials, business services and materials, as well as certain growth-oriented stocks in more traditionally defensive sectors, such as services public.