Around the world economies are slowing, with some developed markets likely already in recession thanks to tightening monetary policies. Nowhere is this more apparent than in the United States, where the US Federal Reserve (Fed) has moved more aggressively than in any other rate-rising period since the 1970s.
A lot has changed in the past 12 months but, from a market perspective, the 450-basis point pop in interest rates trumps all other market influences.
Against this backdrop and recognising that interest-rate changes can have a lagged impact on the economy and corporate profitability, it may take some imagination to paint a constructive scenario for the US stock market.
While we are not out of the woods yet, we are beginning to see some positive catalysts that brighten the outlook. The US is taking its ‘inflation medicine’ quicker and earlier than other Western economies and this points to opportunities in some areas of the stock market, namely small- and mid-caps.
If one believes that the US economy will bottom out in the next 12 to 18 months, it is very likely, in our opinion, that the stock market could react positively six to nine months earlier. This suggests that we could see a material recovery before the end of 2023.
One particularly interesting observation is how smaller-cap companies performed going into a recession, as well as in the subsequent years.
During the past six US recessions going back to 1980, without exception, in the 24 months prior to a recession, large-caps outperformed small-caps. However, almost immediately upon entering a recession, smaller companies reversed and outperformed large-caps for the next three years, again, without exception.
Another factor that we believe will support US smaller companies, is the secular trend of ‘on or near-shoring’ which is a distinct tailwind for more America-centric companies. This trend creates jobs in the US for companies that operate primarily in that market, a clear benefit for small- and mid-caps.
There are clear indications that higher quality investments should fare better in the coming year. Multiple compression, as the market experienced for much of 2022, could accompany rising rates although much of this should already be embedded in stocks.
In contrast to 2022, market performance in 2023 will likely be tied more closely to fundamentals. A slowing economy and generally weaker demand relative to this past year will necessitate costs, including labour, come into equilibrium with slower revenue growth.
This implies risk to corporate earnings given expectations for a very different backdrop from that experienced in 2022, wherein corporate earnings were supported by a resilient US economy.
Quality companies, which have the financial independence to continue to invest in their operations and the business model flexibility to adjust quickly in a dynamic environment, have become increasingly attractive investment opportunities.
Pricing flexibility, for example, will be critical as interest rates rise, inflationary pressures from labour and materials persists and overall demand weakens. This scenario spells certain pressure on margins and likely earnings disappointments for the average company.
Companies with strong management teams, superior business models and solid financials are in a far better position to navigate these coming headwinds. What’s more, higher quality investments generally did not outperform for much of 2022, resulting in compelling valuations for these businesses as we look ahead.
Turning to earnings fundamentals, the most recent reported earnings provides insights into the strength of earnings growth across all market caps relative to Wall Street expectations and the expectations for future growth.
Relative to large-caps, smaller stocks have stronger absolute earnings growth, with a wider gap between actual and consensus estimates. The small-to-mid-caps universe represents nearly five times the expected growth of large-caps. The point: small-to-mid-cap earnings are considerably stronger.
Taking the fundamental differences a step further, historically, when smaller companies miss sales and earnings expectations they are punished more severely than large-caps. But the opposite was true in the most recently reported quarter.
The reason is straightforward: estimates for smaller companies are already projected to be down 15% from their next 12-month peak while large-cap estimates have not materially moved.
It therefore should not surprise investors that large-caps are more vulnerable when a miss occurs. Today, investor expectations are lower for the smaller companies relative to large-caps. This is also reflected in valuations, where we would argue non-large stocks should have better valuation support given the extreme divergence in relative and absolute valuations of large versus non large.
While all three market caps will likely experience deteriorating earnings expectations as we move through 2023, we can conclude that the fundamental strength and expectations of the small-to-mid-caps appears superior today.
Rob Lanphier is a portfolio specialist of US growth and core equity at William Blair Investment Management. The views expressed above should not be taken as investment advice.