Global SmallCap 2024 Outlook

A rebasing in macro conditions

As the quote from Mark Twain says, “History doesn’t repeat, but it often rhymes.” In the past, when global small-cap valuations are significantly below mid and large caps, a rerating of small caps typically follows. We believe we have seen the start of such a rerating over the last quarter.

The global macro-economic outlook is supportive of the smaller end of the market given that unemployment in the US is secularly low, there is excess saving in the system, and the radical normalisation of monetary policy seems to have run its course, setting the potential for more stable conditions looking ahead.

Central banks in developed markets have turned the tide of inflation, though it remains stubborn with some risk. That said, we expect the more stabilised monetary conditions to be supportive of a rebasing of earnings, with the potential for small-cap earnings growth to surprise in 2024. Though markets were significantly impacted by the rising 10-year yield in 2022 and early 2023, and slowing economic growth, they responded positively to the slowing of rate rises towards the end of 2023.

Attractive valuations with growth tailwinds

In the current market, small-cap companies are cyclically cheap relative to their larger siblings in the large and mid-cap sectors (Figures 1 and 2).

Figure 1: A major disparity in valuations has seen small caps trading at the lower valuation bounds relative to large caps

Relative Forward P/E: Russell 2000 vs Russell 1000, 1985-12/31/2023

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The relative valuation discount of global small caps to large has not been as significant since the start of the 2000s. The early 2000s saw GDP growth perform well as China’s economy grew strongly following their admission to the World Trade Organisation in 2001. This marked a major milestone in the secular rise of China’s economy, and their middle class, and a major step in the maturation of the world economy. Even with major setbacks like the Global Financial Crisis, valuations relative to large followed a secular upward trend. However, this trend reversed at its peak around 2011, coinciding with the peak in the resources boom, and the start of a period of significant global displacement and volatility such as the Eurozone Crisis, the Sovereign Debt Crisis and Brexit, and has seen relative values fall steadily to their recent lows. We believe that with the normalisation of monetary policy worldwide, and the re-emergence of China from years of COVID problems and strong fiscal investment in the US, we are at a turning point for global small caps that will see values resurge relative to larger peers.

Figure 2: Mid-caps are trading at a near record premium to small caps

Relative Forward PE of Russell Midcap vs Russell 2000, 1985-12/31/2023

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In terms of total returns in the period from 2000 to the present, small caps have delivered historical outperformance consistent with the thesis that in the long term, smaller, faster growing companies can outperform larger ones (Figure 3). While it is not always the case that smaller companies will beat larger companies, the recent journey of the ‘Magnificent 7’ being a case in point, given the current disproportionate valuation gulf between small companies and their larger peers, the potential for rerating and retracement of value is significant.

Figure 3: Small caps delivered strong performance versus mid-caps and large caps from the early 2000s when small caps were last at a large valuation discount

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Today we face an uncertain future with political and economic uncertainty. Numerous countries have major elections this year, including the US. Global Interest rates sit at the highest level for a decade. However, there are also significant growth tailwinds which we believe will benefit sections of the small-cap market.

Huge fiscal stimulus from the US has reached US$2 trillion in future spending. The Infrastructure Investment and Jobs Act (2021) is providing US$1.2 trillion in stimulus, including US$550 billion of new federal investment in America’s roads and bridges, water infrastructure, economic resilience, internet, and other initiatives. The Inflation Reduction Act (2022) has added US$500 billion in stimulus through spending and tax credits. The CHIPS and Science Act (2022) - CHIPS (Creating Helpful Incentives to Produce Semiconductors) - has added US$280 billion in funding for American semiconductor research, development, manufacturing and workforce development.

The themes of on-shoring, decarbonisation, modernisation and expansion of the electrical grid, and the rapid onset of artificial intelligence will drive investment and innovation in the years to come. In Emerging Markets, India is growing at a rapid pace while China is stepping up its stimulus to ensure growth is maintained at a robust level. These growth and earnings tailwinds are expected to benefit small-cap companies in the coming years.

Conclusion

The combination of attractive valuations, growth tailwinds, global stimulus and secular thematics are offering exciting opportunities for global small caps to build clients, generate strong earnings growth and expand their operations. The current valuation disparity suggests that capturing these global thematics from a lower valuation base should see superior earnings growth from secular thematics drive values in 2024 for key beneficiaries. In the current environment, not only are global small caps in our opinion unrecognised growth opportunities, the entry point for capturing the earnings growth on offer is far cheaper on a relative basis than for larger peers.

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Capital is at risk. The value and income from investments can go down as well as up and are not guaranteed. An investor may get back significantly less than they invest. Past performance is not a reliable indicator of current or future performance and should not be the sole factor considered when selecting funds.