Once again, the US economy has proved itself to be remarkably resilient, with it Q3 growth figures far exceeding market expectations.
Now, as inflation continues to decelerate and markets price in rate cuts, the prospect of a soft economic landing in 2024 appears to be growing.
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This is particularly good news for US smaller companies, which have borne the brunt of heightened risk aversion.
Smaller firms have historically traded at a premium to large-caps due to their higher risk/return profile, but over the past few years this trend has reversed.
Small-cap stocks are not only trading at a discount to their larger counterparts, but at a level not seen in decades.
As risk appetite returns, and fundamentals once more prevail over sentiment, the extreme relative valuation discount of smaller companies looks increasingly attractive.
Shifting spending patterns favour smaller firms
One of the primary forces behind the US economy’s resilience has been the continued strength of consumer spending.
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A strong jobs market with a high level of employment means US wages are rising, while excess savings are also at historically high levels.
US consumers are also less immediately exposed to the steep rise in interest rates than many other countries because around 90% of US mortgages have been fixed at long-term interest rates well below today’s high rates.
Spending patterns are shifting, too. During the Covid pandemic, the goods economy remained robust while the services economy effectively shut down.
We are now seeing this imbalance swing the other way, with evidence of a concerted catch-up in services spending.
This should boost the relative earnings growth of smaller companies, the earnings of which are more tied to services than larger firms.
At the same time, US companies, have moved quickly to downsize or refinance their debt since the pandemic, resulting in generally healthier balance sheets, more cash and less exposure to interest rate fluctuations.
Another key trend is the continuing shift away from globalisation towards more locally-driven supply chains.
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Smaller companies, which tend to be more geared to the domestic economy, stand to benefit more from this trend than larger firms and offer a more diversified exposure to the vitality of the US economy.
Pricing power a key advantage if inflation proves stubborn
A key risk to the outlook is if inflation necessitates further rate increases.
Rising inflation and higher interest rates would certainly cloud the outlook for smaller companies, but even if this transpires, there are many smaller companies that display that all important attribute – pricing power.
Smaller companies are often assumed to be price takers, with limited ability to exert pricing power.
In fact, many smaller businesses operate in underserved or niche industries, such as fintech, computer gaming, e-commerce and green energy, and so command more pricing power than their size might suggest.
When these businesses begin to experience inflationary pressure, be it through supply chain bottlenecks, wage increases, or due to rising input costs, they are able to pass on these higher costs to customers, thereby helping to protect their profit margins.
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Even if a smaller company cannot control the price of an end product, it is not necessarily powerless to influence its own revenues/profits.
For example, many smaller companies can be critical components within more complicated processes or supply chains.
As has been painfully clear in recent years, high demand and limited supply of any component along the supply chain gives pricing power to the component producer.
Smaller, asset-light companies offering business critical services/products look particularly well placed to deliver recurring cash flows and potentially grow their revenues.
Strongest opportunities may lie in ‘less studied’ sectors
While a more positive economic outlook looks set to boost smaller companies at a broad level, improving productivity is likely to be a key driver of top-line performance at a company level.
With that in mind, there are many opportunities to be found – typically in less studied sectors, where the benefits of improved productivity have yet to be fully realised.
Some of the most important aspects of our lives, for example in areas like financial services, healthcare and agriculture, have not really been ‘reimagined’ in the way that technology and communications have.
We are seeing significant investment in these areas, and innovative smaller companies are frequently at the forefront of this advancement.
If the US economy continues to show resilience, there are good reasons to believe that smaller companies will perform well in the period ahead.
Relative valuations versus larger companies have fallen to historically low levels despite earnings remaining relatively resilient, and history tells us that small caps outperform strongly in an improving economic environment.
With powerful onshoring trends and a strong dollar also providing tailwinds, investors may wish to consider adding small cap exposure, focusing on those businesses driving productivity gains – and/or that command pricing power.
Ritu Vohora is an investment specialist at T. Rowe Price
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