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.
To read the publication in its entirety, please click the button below "Download PDF".
Request Accessible PDF
An accessible PDF allows users of adaptive technology to navigate and access PDF content. All fields are required unless otherwise noted.