How 2023’s ‘low growth environment’ could affect small caps

There could be a real turning point for equity markets in months ahead amid rising interest rates and inflation, according to a leading portfolio manager.

Speaking at a Morningstar panel on the occasion of International Women’s Day, Katie Hudson, a portfolio manager and director at Yarra Capital Management with a focus on small and mid-cap Australian stocks, explained why 2023 had marked “a real turning point”.

“We've had 10 years of declining interest rates and that really spoke to multiple re-rates to markets. When you’ve got these big turning points, you have to start thinking very differently about what the environment is going to be like going forward,” Hudson said.

“A lot of people have debated about a hard or soft-landing recession. We’re thinking more about what's over the horizon and what it’s going to look like on a two, three, four-year horizon.

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“When we think about that lens, I think we're in an environment of lower growth. Low interest rates have been a big tailwind for a long period of time and a number of global markets and economies have got population growth as a headwind. Australia is relatively better in that sense, and a number of important countries like China and [in] Europe have got really big population headwinds. 

“All those things together really aggregate to what will be a lower growth environment. We're spending a lot of time thinking about which companies will be winners in that environment and it will be companies that can take market share, grow their earnings, and generate real cash flow.”

Reflecting on the past reporting season, Hudson said companies seemed to have been most surprised by margin crunch in the current inflationary environment.

“A lot of things went the way we hoped, which was good, but I think people were probably most caught out by a margin crunch.

“Companies reported really strong revenue growth through reporting season, mainly due to price, not volume,” she explained.

Overall, about half of companies missed expectations around margins, she said.

“I think the most overused phrase last year by investors and everyone else was ‘pricing power’. Everyone was saying they’re investing in companies with pricing power, and we’re starting to see evidence of some early price fatigue.

“The impact of that price growth resulted in volume impacts, and consumers starting to trade down, values starting to be evident.

“I think it’s probably the margin headwind that’s caught people on the top and as a consequence, we've seen earnings expectations downgraded which is what we thought would happen but it’s probably surprised people as far as how quickly that's happened.”