For the first time in over a decade, a new economic cycle is underway – a ‘reflation’ cycle characterised by faster economic growth, higher inflation and ongoing monetary and fiscal stimulus, which is going to benefit small businesses globally.
Advisers and investors should anticipate quality assets that have been underappreciated for some time again becoming sought after, as the trends that defined the post-Global Financial Crisis (GFC) period make way for new themes. Specifically, the following themes are expected to become features of the investment landscape:
- In a durable economic upturn, improved profitability is likely to provide value stocks with the ‘scarcity’ factor previously enjoyed by growth stocks. At the same time, rising bond yields will leave the questionable valuations of growth stocks vulnerable;
- The greater breadth of economic activity, across and within economies, will allow smaller businesses to benefit – particularly those leveraged to the forecast strength in consumer and capital expenditure; and
- Stronger economic and market performances are anticipated beyond the US – notably in Europe where there remains ample scope for an extended growth phase. Indeed, official projections are for European growth to outpace that in the US over the next five years.
LOOKING BACK – CRISES BOOST SHARE MARKETS
Who would have thought that a global crisis or two would actually benefit equity investors? It’s 13 years since the GFC and almost two years since the onset of COVID-19 and, in each case, investors have reaped strong gains following the initial ‘shock’.
In the case of COVID-19, global central banks simply dusted off the successful GFC playbook: Quantitative easing resumed, bond yields registered new lows and markets rebounded. Meanwhile, the future was brought forward, as the take-up of digital technology accelerated. COVID-19, therefore, intensified two of the most pronounced themes that have driven investment returns since the GFC:
- Lower bond yields and weak growth reinforced the market bias in favour of growth stocks (those with favourable long term profit prospects) over value stocks (those with high profitability today); and
- The technology revolution, in which businesses involved in hardware, software, streaming services, social media and internet shopping – especially the dominant US names – have flourished.
THE NEW ECONOMIC CYCLE
However, as the global COVID-19 threat eases, the economic disruption of 2020 is giving way to other powerful forces:
- A combination of massive policy stimulus, a surge in house prices, high rates of precautionary saving and pent-up demand has created a potent cocktail for consumer spending across the major economies;
- Infrastructure spending plus bottlenecks in industries from semiconductors to healthcare and transport are igniting an investment boom. Indeed, Standard and Poor’s estimate that the world’s largest companies will undertake capex worth US$3.7 trillion ($5.1 trillion) in 2021, while The Economist states that the capex boom “may only be getting started”; and
- Global growth has become strongly synchronised as authorities have adopted a clear ‘pro-growth’ stance. Moreover, policymakers are likely to err on the side of caution in removing stimulus, with the International Monetary Fund (IMF) urging supportive monetary and fiscal policy “wherever possible” and “until the pandemic ends”.
POLICY UNDERWRITES THE EXPANSION
The cycle is also being driven by a philosophical shift on the part of policymakers. In the US, for example, the fiscal response to COVID-19 amounted to a whopping 25% of gross domestic product as at June 2021 and is expected to rise further with the Infrastructure Investment and Jobs Act which is being viewed as a “generational investment” for the US economy.
In Europe, the European Central Bank has adopted a more inflation-tolerant and growth-supportive stance by announcing a subtle but important change to its inflation target (from “below, but close to, 2%” to “2% over the medium-term”) and a commitment to meet the target through “persistently accommodative monetary policy”.
These policy shifts are likely to play out over years, providing enduring support for the ‘stronger and broader’ growth theme and for small companies in sectors and regions that have lagged over recent years (including quality smaller companies in Europe and those geared towards consumer demand and business investment).
SEARCH FOR VALUE
Under unique circumstances, investors cannot assume that the strategies of recent years will continue to deliver. Strategies and portfolio positioning must adapt to the new environment and while absolute returns may be a little harder to find, a quote by billionaire Berkshire Hathaway investor Charlie Munger highlights the importance of searching for value: “all intelligent investing is value investing – acquiring more than you pay for”.
Today, that value is likely to lie in previously ‘unloved’ places. We favour exposures in quality smaller companies in Europe. We also encourage investors to look to businesses that are likely to benefit from the release of pent-up consumer demand and the capex surge.
Although these themes are expected to play out over an extended period, short-term indications are already supportive. European markets have outperformed the US over recent months – including smaller companies – while there are early signs of a rotation to value and relative gains within the industrial and consumer sectors. It’s early days, however, and investors still have time to capitalise.
VALUE IN SMALL CAPS
After underperforming for much of the past decade, ‘value’ certainly describes the small cap sector, as shown in Chart 1.
The chart shows the highly attractive valuations of US and European small versus large cap stocks (in a single indicator), with small cap valuations currently trading 28% below the long-term average.
HISTORY PROVIDES A GUIDE
Providing additional context, Chart 2 shows three cycles in the performance of US small versus large-cap stocks over the past 30 years, including the following episodes of small-cap outperformance:
- Up to February 1994 (three years, nine months): the 1990-91 recession and Gulf War saw smaller companies commence a cycle of outperformance that began in November 1990 and provided excess returns of 50%;
- March 1999 to April 2006 (seven years, one month): an extended upswing, incorporating the US ‘tech wreck’ recession of 2001 and subsequent credit fuelled growth, saw small cap stocks outperform large cap names by 94%; and
- April 2008 to March 2014 (five years, 11 months): the GFC and widespread implementation of quantitative easing saw smaller company returns exceed those of large caps by 28% during this cycle.
The average duration of these four upswings is 5.5 years, with small-cap stocks outperforming by an average of 57%. Assuming a similar cycle length from the August 2020 low in the small-cap performance ratio, suggests an upswing potentially extending into 2026.
RECESSION AS A PRELUDE TO RECOVERY
A recession featured relatively early in each of the three periods of small cap outperformance. This relates to the profit recovery and improved risk appetite – both of which favour the performance of small-cap stocks – which typically follow recession (but may be anticipated by the market prior to the conclusion of the recession).
Taking the 1991, 2001 and 2008 recessions as a guide, peak small-cap performance was achieved, on average, four years following the recession. On this basis, it’s not unreasonable to expect the current small-cap cycle to extend well into 2024.
To conclude, the valuation and economic setup is in place for a cycle of small-cap outperformance. While investing has always been, and will always be inherently uncertain, history suggests we are only in the early stages of the upswing.
Stephen Milch is a consulting economist at Pengana Capital.