CONTRIBUTORS
Francis Gannon
Co-Chief Investment Officer, Managing Director
Will the US/major economies be able to avoid a recession? Soft or hard landing?
It seems as if we have been talking about the prospect of a recession since the end of 2021. While we are not in the business of predicting when or if the economy will fall into recession, we do believe the small cap market has already priced in a recession and many companies have been preparing for the possibility of one for some time.
How do you see the rate and inflation path in the US/major economies in 2024?
Using history as our guide we know that small cap returns in the first year of Federal Reserve (Fed) Funds tightening have usually been good. Surprisingly, in the 12 months that followed the first Fed interest rate hike in March 2022, the Russell 2000 was down -11.5% while the S&P 500 was down 7.0%. History shows that 1- and 3-year returns for both indexes were mostly positive following the nine previous initial tightening cycles by the Fed.
At the same time, we know that the subsequent average one-year return for the Russell 2000 Index following the final rate hike is quite strong, averaging 18.4% going back to the mid 1990’s.
Is a Recession Already Priced into the Market?
1- and 3-Year Performance from Initial Fed Tightening (%)
As of 9/30/23
Sources: Russell Investments. *Last twelve months Enterprise Value/Earnings Before Interest and Taxes. Past performance is no guarantee of future results.
What catalyst could drive a significant shift/rebound in your asset class in 2024?
Small-Caps remain mired in a classic bear market, down close to 25% from their peak on November 8, 2021. In addition, it has been well over 500 trading days since the Russell 2000 last closed at a 52-week high, the third longest streak in the Index’s history. The last few months are much of the same, as the Russell 2000 has declined for three straight months through the end of October, down over 16.7%. We see an array of potential triggers that would jump-start small-cap performance, which include the end of the rate hiking cycle, inflation moderating, a labor market that remains strong and consumer spending steady. The strength of capital spending, the reshoring phenomenon, the effects of the CHIPS and Science Act, and AI applications are all highly promising elements whose benefits haven’t yet registered fully, if at all.
Where do you see the best investment opportunities for 2024?
As bottom-up small-cap stock pickers, however, the most significant factor for us is that the majority of the management teams we’ve been speaking to remain cautiously optimistic over the long run. So, while the near-term view is as cloudy as any we’ve seen, there are enough positives for us to have a very constructive view for long-term small-cap returns going forward. Valuations for small-cap stocks are looking more attractive in aggregate. Small caps finished October in a bear market, with the Russell 2000 losing -30% from its last peak on 11/8/21 through the end of the third quarter. Many companies we’ve looked at would appear to have already priced in a recession. Both in terms of price-to-earnings (P/E) and EV/EBIT (enterprise value over earnings before interest and taxes), many small caps look undervalued to us. They look even cheaper compared to large caps. In fact, based on EV/EBIT, small caps remained close to 20-year lows relative to large caps at the end of September. So, the opportunity set in small cap does look compelling to us from a valuation standpoint.
Relative Valuations for Small Caps vs. Large Caps Are Near Their Lowest in 25 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT* (ex. Negative EBIT Companies)
From 9/30/98 through 9/30/23
Sources: FactSet, Russell Investments. *Last twelve months Enterprise Value/Earnings Before Interest and Taxes. Past performance is no guarantee of future results.
Focus on quality and active management throughout small-caps…given the dramatic change in access to capital, we believe better companies should continue to outperform in these uncertain times. We remain focused on industrials, financials, and information technology.
What are the main areas of risk in 2024?
The usual list including geopolitics, the US Presidential election, or a crack in the financial system.
What could be a major surprise to markets in 2024? Or what risk factors/opportunities are markets currently not adequately discounting for 2024?
Our confidence is that the asset class itself is poised for recovery. The Russell 2000 Index had an annualized return of just 2.4% for the five-year period ended 9/30/23. This was among the lowest five-year returns since the inception of the Russell 2000 and shows that many small caps have essentially been treading water for the last five years. And while the last five years have been a very trying period for small-cap investors, especially when weighed against the markedly higher returns for large cap over the same five-year span, our long-term confidence is high. We’ve talked before about how these lower-than average annualized five-year returns for the Russell 2000 have historically led to higher-than-average returns over the next five years. The Russell 2000 had positive annualized 5-year returns 100% of the time—in all 81 five-year periods—averaging 14.9%, which was well above its monthly rolling five-year return since inception of 10.4%.
Definitions
The Russell 1000 Index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded US companies in the Russell 3000 Index.
The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index.
The Standard & Poor’s® 500 Index (S&P 500®) is a market capitalization-weighted index of 500 stocks designed to measure total U.S. equity market performance.
The price-to-earnings (P/E) ratio is a stock's price divided by its earnings per share.
Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.
The EV/EBIT multiple is the ratio between enterprise value (EV) and earnings before interest and taxes (EBIT).
The CHIPS and Science Act is a U.S. federal statute enacted by the 117th United States Congress and signed into law by US President Joe Biden on August 9, 2022. The act provides roughly $280 billion in new funding to boost domestic research and manufacturing of semiconductors in the United States.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Data and figures quoted in this article sourced from Russell Investments, Bloomberg and Reuters.