Small cap tailwinds on the horizon

After lagging large caps significantly in recent years, global and domestic small cap benchmarks are showing improved performance in recent months.

Small caps generally underperform large caps in the lead-up to an economic slowdown and this cycle has been no exception, with both global and Australian small caps underperforming significantly since 2021.

In our view the fourth quarter of last year likely marked a turning point for small caps, due to increasing evidence of relatively resilient economic data (no hard landing) combined with easing inflationary pressures. This has helped build optimism for a global and domestic soft landing, with rate cut expectations factored in for later this year. This should provide the foundations for a strong comeback in small cap benchmarks in 2024 and 2025 as global and domestic economic growth picks up again.

Figure 1: Global small caps have underperformed large caps in recent years

Figure 2: Australian small cap performance appears broadly correlated with global performance

Discounted relative valuations for small caps

Despite the improved performance in recent months, small caps still trade at a very wide and historically attractive discount relative to large cap stocks. Indeed, global small caps are trading at the largest discount to large caps in over 20 years. When small caps traded at large discounts in the past, they have historically often gone on to deliver strong returns over the following 12 months, most particularly when the macro and policy backdrop turns “supportive”.

Figure 3: Global small caps are trading at a historically large discount to large caps

Economic cycle should turn more supportive

Historically, small cap equities have outperformed relative to large cap equities in early, or expansionary stages, of the economic cycle, as growth begins to pick up again. It has often been the case that small caps have been relatively cheap as the global business cycle moves into a new expansion phase, i.e. 2003, 2009, 2020. These particular years saw strong absolute and relative performance from small cap-equities. In the case of 2003 and 2009 it proved to be the start of a multi-year period of outperformance.

Small cap outperformance and Fed rate cut cycles

The monetary policy cycle has also tended to be important for considering small cap relative performance potential. Small cap equities have historically outperformed large caps in the year after an interest rate peak as policy is eased. On average, global small caps have outperformed large caps by more than 10%.

Figure 4: Global small caps typically perform well after Fed rate cuts

After a significant and rapid hiking cycle both globally and domestically, which encouraged outflows from the small cap sector, there is building consensus that rate cuts will happen in 2024.

There remains some uncertainty as to exactly when and by how much rates will be cut this year. Current consensus expectations suggest the US Federal Reserve will begin cutting policy rates in June, with the RBA following a few months later.

We are cognizant of the risk of the lagged impact of tighter monetary policy as well as the higher-for-longer rate scenario. However, in our view, there are encouraging signs of a soft-landing scenario for both the US and global economy. The Australian economy also appears on track for a soft landing in 2024 followed by a growth pick up next year in response to lower policy rates.

While it may not be a perfectly smooth ride, with valuations looking compelling, and the prospect of easier monetary policy encouraging a pick-up in growth over the next 12 to 18 months, we expect the small company asset class to perform well over the coming year and most likely beyond.

Alpha over beta in smalls, but beta helps

It is reasonably well established that small caps are an inefficient asset class and are better suited to an active approach. Indeed, alpha generation is ultimately the key to success in small caps. This is particularly the case in respect of domestic small caps, where the benchmark appears quite inefficient.

It is noteworthy that the domestic small cap median manager has a well-established track record of outperforming the small cap benchmark by a considerable margin. Indeed, the domestic small cap median manager has marginally outperformed its large cap peer over the past 10 years. Nevertheless, the prospect of a stronger period for the small cap benchmark would be the icing on the cake for the asset class. Small cap sweet spots can lead to very strong return phases when combined with ongoing active manager alpha.

Figure 5: Australian small cap managers typically significantly outperfom the small cap benchmark

Source: Refinitiv, Wilsons Advisory.

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