Disinflation is the key to a brighter future for US small and mid caps. After a disappointing ten months, the Russell 2000 Index rallied 5.5% while the S&P Midcap 400® Index climbed 3.9% on 14 November on the back of core CPI moderating to +0.2% month on month, and the headline annual number at 3.2%.1
Meanwhile, US GDP growth numbers surprised to the upside with a 4.9% annualized expansion in Q3 as consumers in the US remain resilient thanks to a tight labour market. A goldilocks scenario for cyclical and domestic US small and mid caps may be unfolding.
US equities saw divergent performance year to date, with a narrowly driven rally in the S&P 500® Index while the broader market lagged. Small caps underperformed for the first ten months of 2023 as investors had been expecting a recession for the better part of the year. But moderating core and headline CPI combined with exceptionally strong US economic growth may drive a broadening of the rally across US equities, benefitting exposures that are more domestic, more cyclical, and higher risk/reward — like small and mid caps.
Figure 1: 2023 Year-to-date Performance
Core CPI inflation month over month is just +0.2%, and headline CPI is +3.2% year on year. Both indicate that the battle against inflation is being won, perhaps at a faster pace than market participants anticipated. Disinflation is a crucial consideration from a risk standpoint, as the key risk for small caps, mid caps, and the US economy in general stems from higher interest rates, which could create a systemic shock through refinancing channels. Broadly speaking, we don’t expect the US economy to hit the “refinancing wall” until 2025. If disinflation continues at the current pace, the Fed may be able to deliver more rate cuts in 2024 than are currently priced in, mitigating shocks to the broader economy. This would provide support for both small- and mid-cap companies which are not only smaller but also more cyclical.
Growth dynamics are becoming equally important. At the start of the year, many economists were pencilling in a US-centric slowdown, with consensus pointing to a modest 0.3% growth rate. As the year progressed, the US economy emerged as a leader of global growth in the developed world, with its GDP growth forecast improved to 2.3% for the entire year. The 4.9% annualized growth in Q3 came in well above estimates, driven by consumer spending and fiscal policy. It’s not likely that disinflation combined with a recession would be sufficient for small caps to rebound. But the rare combination of moderating price growth and stronger-than-expected economic expansion is a supportive factor.
Figure 2: 2023 US GDP Consensus Estimates
Another remarkable element of the US macroeconomic picture is that, while the battle against inflation is being won, it is being achieved without significantly harming the labour market. Headlines point to a softening, but let’s take a step back and look at the bigger picture. Unemployment has recently ticked up, but only to 3.9%. Job openings at 9.6M is below the peak, though still one of the highest numbers this century, and the ratio of job openings to unemployed is 1.5x. This likely prevents job insecurity concerns, allowing for US consumer spending in more discretionary segments.
Figure 3: US Inflation and Unemployment
A resilient consumer is the bedrock of domestic small- and mid-cap (SMID) exposures. Companies within the Russell 2000 generate 80% of their revenue in the US, while stocks in the S&P Midcap 400 Index derive 76% of their revenue domestically. Meanwhile the S&P 500 Index generates 60% of its revenue inside the US, thus is slightly more exposed to the global economy which, by and large, is not recovering at the same pace as the US. That said, we remain constructive on the S&P 500 relative to other large-cap exposures given US strength and its more domestic profile compared to indices such as MSCI Europe or MSCI Japan.
Figure 4: US/Non-US Index Revenue Breakdown
Cyclicality, domestic profile, and catch-up potential are key similarities between small and mid caps. However, there are some notable differences, mainly in their risk/reward profiles. The most obvious difference is size as the median market cap of companies in the Russell 2000 Index is $769M; for the S&P Midcap 400 Index, the corresponding number is $5.7B. Looking through a sector and industry lens, small and mid caps are both cyclical so may benefit from a strengthening US economy and improved inflation backdrop. The Russell 2000 Index, however, offers higher exposure to biotech and software while the S&P Midcap 400 Index overweights more traditional companies, making industrials the largest sector. Longer term, initiatives like the Infrastructure Investment and Jobs Act, CHIPS and Science Act, Inflation Reduction Act and broad reshoring efforts are likely to benefit more domestic and industrials-heavy mid and small caps.
Figure 5: US Small and Large Cap Index Sector Breakdown