Small stands tall in the face of inflation

Bottom line up top

Global investment performance continues to be driven by a familiar set of thematic drivers: tight labor markets, stronger-than-expected wage growth, sticky inflation, restrictive monetary policy, economic resilience (or not) and fraught geopolitics, to name a few. With each new data point or headline, many investors find themselves attempting to adjust their portfolios based on their best guess at which pithily named outcome is most likely: a “soft landing,” a “hard landing” or — most confusingly — “no landing.”

Making sense of the trends and terminology is like trying to figure out why a coffee shop labels its small serving size “tall” and its medium size “grande” (though of course the financial stakes are far greater when it comes to investment portfolios). But even if accurately predicting the trajectory and magnitude of key economic indicators is, well, a tall order, we know with certainty that higher-for-longer policy rates aimed at squelching inflation have taken a toll on the global economy (Figure 1). What’s more, as the “last mile” of disinflation continues to be run at a tortoise-like pace, we anticipate central bank rate cuts will remain on hold, likely leading to further economic deceleration.

In this environment, equity investors in particular need to stay vigilant and nimble given extremely narrow market leadership and extended valuations, most notably among large cap stocks.

Portfolio considerations

Bigger isn’t always better. U.S. small cap equities underperformed their large cap counterparts by nearly 10 percentage points in 2023, causing the forward price-toearnings (P/E) ratio of the small cap Russell 2000 Index versus the large cap Russell 100 Index to hover near its lowest level since December 2001 (Figure 2). With large caps looking quite expensive on this basis, valuations currently favor small caps.

But valuations aren’t the only factor to consider when gauging the relative attractiveness of equities. Resilience in the face of sticky inflation is also important. We believe the fundamental characteristics of smaller companies — especially those with pricing power to mitigate the impact of inflation and protect or expand margins — make them a compelling choice for inflation-wary investors.

Selectivity matters as much as size. Of course, not all small cap sectors offer these potential advantages to the same degree, and some are experiencing earnings pressures. We’re less constructive on consumer-oriented stocks and prefer high-quality companies exposed to enterprise revenue, a more reliable source of cash flows. The industrials sector, for example, is supported by fiscal policy initiatives such as infrastructure spending and nonresidential construction. Within information technology, areas like software and semiconductors warrant consideration. Software companies in particular are notable for their durable business models and inelastic demand for their products and services.

A small world, after all. With opportunities available around the globe, small cap allocations needn’t be limited to U.S. names. Exposure to non-U.S. small caps can enhance portfolio diversification and improve risk-adjusted returns compared to non-U.S. large caps. In fact, in the non-U.S. arena, small caps have outperformed large caps by more than 250 basis points (bps) on an annualized basis since 2001, with only slightly higher volatility. Even with this outperformance, non-U.S. small caps remain attractively priced, trading at a 10% valuation discount to their large cap peers. Lastly, research coverage of the non-U.S. small cap universe is relatively low, providing a potential advantage for active management.

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