Sizing Up Small-Cap Growth For 2023

Portfolio Manager Jonathan Coleman explains how volatility, valuations, and earnings for small-cap growth equities inform his views on the asset class for the year ahead.

Key takeaways:

• The small-cap growth market has remained in a relatively tight trading range in recent months, but with volatile swings as investors bounce between euphoria and pessimism.
• Following the excesses of previous years, the asset class now generally seems to be trading on fundamentals and more in line with historic valuations, and it appears cheap relative to large caps. Coupled with improving inflation data, this leads us to be relatively optimistic heading into 2023.
• While we expect an economic downturn and believe the Federal Reserve (Fed) could overtighten in pursuit of milder inflation, we also think a slowdown could provide an opportunity for individual companies to differentiate themselves.

The small-cap growth market has been relatively rangebound since the second quarter of 2022, but it has been “violently” flat, with extreme ups and downs driven by the latest headlines and economic data. Periods of euphoria – on hopes that the Fed may be near the end of its rate-hiking cycle – have been counterbalanced by pessimism that the central bank must do more to slow inflation, harming economic growth and corporate earnings in the process. In the fourth quarter of 2022, we began to see small caps generally trade on fundamentals again and take market news more in stride than earlier in the year, but we expect volatility will persist moving forward.

Digesting the current economic situation

Though the economic outlook remains uncertain, we have begun to see improvement in metrics that could signal slowing inflation. Supply chains are slowly improving, with excess capacity now surfacing in areas where supply was previously constrained. Two consecutive months of Consumer Price Index (CPI) readings have shown year-over-year inflation easing slightly. With the back half of 2022 now marking positive momentum in this regard, there is the potential for annualized CPI rates to begin to normalize closer to the Fed’s long-run target of 2% by late 2023.

At this point, we believe the Fed’s intentions have been telegraphed clearly and have been largely anticipated by the market. That said, its policies also take significant time to ripple throughout the economy, especially considering the speed with which the Fed has raised rates in the current tightening cycle. Wage inflation has remained stubbornly high and labor participation abnormally low, forcing the Fed to continue to act until the labor market softens. The unpredictability of the Russia/Ukraine war has added complexity to an already difficult task. If we see a positive resolution in 2023, this development would be welcomed by markets and likely relieve some upward pressure on prices, particularly in commodities.

The complicated nature of the situation leaves open the possibility that the Fed may tighten too much. Going forward, the eventual effects of higher rates on the economy and, ultimately, corporate earnings, remain significant concerns.

Forces working in small cap growth’s favor

We will closely monitor earnings, yet it is instructive to note that the stock market can perform better than some might think in a recession. As we discussed in our earlier article, small-cap performance during recessions has often been resilient, with the potential for significant growth as the economy recovers. Coming out of recessions, small-cap fundamentals − and stock prices – historically tend to bounce back stronger than their large-cap counterparts.

We have seen a clear trend toward reshoring and deglobalization following the pandemic and recent geopolitical turmoil. Bringing supply chains back to the U.S. could benefit smaller-cap companies, which tend to be more U.S.-centric than larger multinationals. The Fed’s significant tightening has also resulted in a significantly stronger dollar. While the strength of the dollar has now moderated to some extent, a stronger dollar is largely positive for companies with more domestic operations and exposure.

Opportunities ahead

While the Fed may err on the side of excessive tightening, given economic data trends and the potential for a market where correlations begin to break down, we are reasonably optimistic heading into next year. It is our belief that when the Fed is done with rate hiking, stocks can perform well again. We expect there will likely be a recession, but also believe that with a downturn will come opportunity for quality growth companies to differentiate themselves. For us, this represents an opportune time to be active by assessing the variables impacting companies and sizing up what we believe will be the long-term winners and losers.

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Originally Posted January 5, 2023 – Sizing up small-cap growth for 2023

MPORTANT INFORMATION

Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.

Definitions

Quantitative Tightening (QT) is a government monetary policy occasionally used to decrease the money supply by either selling government securities or letting them mature and removing them from its cash balances.

Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics.