It’s time to dig deeper for opportunities as equities become more expensive. In an environment of U.S.-led reflation—accelerating inflation and nominal growth driven by an awakening of animal spirits and expectations of fiscal stimulus—we see potential for outperformance in equity style factors such as value (the cheapest corner of the market) and size (small and mid caps).
Returns on equity factors have been volatile since the financial crisis, with value and size rebounding in 2016 after weakness in the previous year. Both of these factors are influenced by cyclical drivers. See the chart below.
The case for value equities
We see further upside in value stocks as the U.S. shows signs of faster growth. U.S. hourly wages have broken out to the upside, increasing in December by the most since 2009. The ratio of upgrades to downgrades in global earnings estimates has risen to a six-year high. Accommodative monetary policy, weaker currencies and stronger demand are supporting earnings globally.
Financials, a value heavyweight, led an equity market rally into year-end. The prospect for steeper yield curves boost banks’ net interest margins—the gap between lending and deposit rates. Expectations for Donald Trump’s administration to reduce regulations support the bullish case. Yet banks no longer look especially cheap. Investors pursuing a value strategy need to be aware of how quickly revised earnings outlooks and shifts in positioning can transform valuations from cheap to fair.
The energy sector’s weak fundamentals made valuations look pricey, but estimates for operating cash flows have risen as a result of improved cost discipline and supply-and-demand outlooks. We see the sector benefiting from OPEC production cuts and improved earnings prospects.
Small caps poised to extend gains
We see economic reflation supporting more gains in small caps. The U.S. Russell 2000 Index of small caps has outperformed the large-cap Russell 1000 Index by an annualized 2 percentage points in periods of rising rates since 1979, our analysis shows. And small caps’ interest expense burden should be lower this cycle, since many companies have refinanced debt at record low rates.
Small caps will probably enjoy an extra boost after Trump’s election as president on expectations of a resurgence in domestic growth and hopes of less regulatory pressure—particularly for regional banks. Further, many investors see proposed corporate tax cuts disproportionally helping smaller companies.
Some investors are seeking shelter in small caps amid a rising U.S. dollar and fears of trade barriers under Trump. Yet we would caution that U.S. small caps are not perfectly insulated from such changes. The foreign share of revenue for small caps has been catching up with that of large caps, our calculations show. Moreover, many U.S. small caps—particularly in such subindustries as semiconductors and auto parts—are tightly integrated into global supply chains.
We see value and small caps performing well as long as the reflationary environment persists. This is a U.S.-led story for now, but we see broader opportunities as reflation takes root globally. We also see risks. One is high expectations for tax cuts and infrastructure spending under a Trump administration. Execution snags could result in disappointment. Also, the value trade surged in popularity in late 2016, our analysis of positioning and flows data shows. This points to the possibility of temporary reversals. Read more on this in my Global Equity Outlook.
The iShares Russell 2000 Index ETF (NYSE:IWM) fell $0.96 (-0.7%) in premarket trading Monday. Year-to-date, IWM has gained 0.99%, versus a 2.43% rise in the benchmark S&P 500 index during the same period.
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