- The emergence of a new economic environment – one of deglobalisation, rising prices, rising rates and inflation – will still affect the US market.
- This domestic focus could provide opportunities for small cap companies, which have previously outperformed in rising rate environments.
- However, we won’t try and second-guess the macro environment, instead sticking to our trusted investment process
It has been an incredible decade or so for US equities. A 10-year-plus period of globalisation in which the companies at the top of the S&P 500 found themselves in a seemingly tailor-made situation: very big, high-quality businesses – such as Amazon, Alphabet, Apple, Microsoft1 – riding a technological wave. And it was a global wave, with the biggest growth not happening in the US and Europe but in China and India – yet still it was US tech giants that benefitted from this.
But in the past few years, since the Covid-19 pandemic and now with the Russia/Ukraine conflict, we have begun to see the emergence of a new environment: one of deglobalisation, rising prices, persistent and high inflation, rising interest rates and recession. We see the global connections that have been built up over the past few decades, particularly in food chains and energy supplies within Europe, for example, becoming problematic. A reliance on other countries, particularly Russia for your gas, is not desirable.
The US stands a little bit apart from this situation. It has relative energy security due to its high domestic production levels, and it doesn’t import as much food as Europe. It is, however, still experiencing rising rates and could well face recession, but it is showing resilience. The US consumer has a huge store of spending power, driven by the huge $5 trillion Covid-19 stimulus package which was designed to shield households and businesses from the pandemic economic shock. This Covid “piggy bank” saw savings hit almost 35% as a percentage of disposable income2 and continues to be drawn upon now, meaning there is a continued high demand for goods and services.
Large caps versus small caps
So what does this all mean for US companies? The US large cap companies will remain phenomenal businesses: we believe Amazon will continue to grow, as will Microsoft and its cloud services. But a turn away from globalisation, a more domestic focus, could prove pretty compelling for US small cap companies. If you look at foreign revenue exposure by market cap size, for example, small caps are much more domestically oriented businesses (Figure 1).
Figure 1: home advantage – median domestic v international revenues by size in Russell 3000
Source: Raymond James, 12 August 2022
We have also seen continuing US dollar strength. Recent dollar surges and the euro and the British pound’s respective slides brought parity between the US dollar and the euro for the first time in 20 years, and not far off for the pound. But a strong dollar will also have consequences for company earnings, as those US companies which source a substantial share of revenues from overseas will discover that the currency strength will eat into profits when foreign currency revenues get translated back into US dollars. By and large, this is an issue for the large cap companies. With small caps, you can almost get the opposite effect: that is, their revenue base remains good, with most of their growth being in the US, but their supply chains remain global. The strong dollar means that their purchasing power gets a little bit stronger.
In addition, what we have seen historically is that that smaller companies tend to lag large caps when interest rates fall but outperform in a rising rate environment. We wrote a paper in 20183 which showed that since 1962, the furthest back we can go for reliable data, in those months when interest rates rose, the S&P 500 returned 6.1% and smaller companies returned 14%; conversely, in the months when interest rates fell large caps returned 14.9% and small caps delivered 10%4.
Figure 2: annualised performance – all rising rate months
Source: Hotchkis & Wiley, 2017
One of the reasons why smaller companies outperform in periods of rising rates and more normal inflation is because that’s generally a sign that an economy is healthy. It is harder to say what that means when inflation is running at 8%-plus. We shall see.
Commercial industrial versus consumer
What is very interesting is that we are seeing, for the first time this century, a clear distinction in performance and experience between different sectors, specifically between commercial industrial businesses and consumer businesses. The former, which are leveraged to the industrial cycle are holding up very well – they are benefitting from on-shoring and automation trends and, anecdotally, struggling to expand and hire people. The US employment market is very tight, with US initial jobless claims as low as around 200,0005. Consumer-facing companies, however, are finding life very different. They are beginning to see a softening in demand, which means a moderation of their top lines and pressure on their cost bases, whether that is in materials or certainly when it comes to labour. Perhaps the residual savings built up from Covid are beginning to wane. Given that the consumer accounts for around 70% of the US economy, we would eventually expect this gap to narrow as weak consumer demand is eventually felt in the industrial complex.
So we have a changing macro picture, on a global and domestic scale. And in the US the Federal Reserve is intent on raising rates and holding them at such a level that they hope will deal with rampant inflation. Reaffirming this narrative, a series of increases have taken the upper bound of the Federal Funds rate to a range of 3%-3.25%, and it might remain there longer than previously expected. In fact, the Fed’s dot plot of rate projections cites a median rate of 4.4% at the end of 2022, implying another 125bps of rate rises over the final two meetings of the year, and a 4.6% terminal rate in 20236.
We won’t try and second-guess the macro environment. Instead, we will stick to our investment process which is research-driven bottom-up stock selection. Our research intensity, carried out both in the US and the UK, produces deeper insight and allows us to identify companies we believe can sustainably improve returns on invested capital, profitability and free cash flow generation, and which are integrating responsible investment considerations in their business models. Those that do this are well positioned to outperform over a market cycle. Running portfolios of the very best stock-specific ideas can help us navigate turbulent markets and produce strong, risk-adjusted returns on a consistent basis.