Portfolio Perspective –

Key takeaways

• Our work suggests the fundamentals of small cap companies are set up for longer-term outperformance.
  
  
• The sector composition of small caps favors more economically-sensitive sectors that should benefit from continued economic growth.
  
  
• Small caps tend to outperform large caps during periods when interest rates are rising and when the Federal Reserve (Fed) is increasing interest rates.
  
  
• Most of small caps’ outperformance tends to be concentrated in the first phase of a new bull market and is usually more mixed in the middle phases.
  
  
• We expect a continued tug of war between strong fundamentals and a supportive macro backdrop versus concerns that most of the small cap rally is behind us as the speed of economic growth takes a step down.

Our take

The fundamentals of small cap equities are set up for long-term outperformance relative to large caps. A key driver of this view is the forward price-to-earnings ratio (P/E) of small caps is trading at a multi-decade low relative to large caps. While valuations aren’t always the best indicator of performance on a shorter-term time horizon, they tend to be much more influential on longer-term relative returns. Additionally, small cap companies have fared well during this recovery, with earnings remaining near a cycle high relative to larger companies.

Our macro team expects above-trend economic growth through 2023, which our fixed income team believes should lead to higher interest rates in the U.S., albeit with more volatility. Given small caps’ economically-sensitive sector composition, we see this as a solid backdrop for outperformance.

That said, small caps are experiencing a tug of war between strong fundamentals and a supportive macro backdrop versus an aging bull market cycle as economic growth takes a step down in pace.

Bottom line

The weight of the evidence in our work continues to point to long-term outperformance from small caps. However, if concerns around the pace or durability of economic growth come to the forefront of investors’ minds, small caps could continue experiencing a bumpy ride over the intermediate term.

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