Head - NAM Investment Strategy
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Small caps no longer have higher long-term expected earnings growth compared to their large cap peers.
We are reducing our US small- and mid-cap exposure to a slight underweight position. Small caps have been the best-performing asset class over the past decade but have lagged large caps over the year-to-date, one-year and five-year time periods. This is consistent with their typical performance which mimics the fable of the tortoise and the hare: small caps have historically outperformed early in new bull markets and lagged thereafter.
The late 2017 tax cuts and 2018 trade uncertainty gave small caps a second wind earlier this year. However, once Canada joined the US and Mexico in a new trade agreement (USMCA) to replace NAFTA, trade fears receded and small caps began to lag in earnest.
Looking ahead, amid tax cuts and deregulation, large cap stocks have narrowed the long-term expected earnings gap that small caps have traditionally enjoyed and the Citi Research economics team expects US GDP to decelerate versus the rest of the world in 2020. If correct, this could be an issue the market wrestles with in 2019. Small caps garner a higher percentage of their sales domestically, at 80%, than do the multinationals in the S&P 500 index, at 62%. Small caps may also be more exposed to tightening US labor conditions and resultant US wage pressures in the quarters ahead, a concern expressed in recent NFIB (National Federation of Independent Business) surveys. Both small and large caps have forward price-earnings ratios near their 20-year averages.
Small cap stocks increased their leverage in an era of low rates. Interest expense as a share of earnings is at the high end of the range versus the low end of the range for large caps, leaving small caps with more exposure to rising interest rates. We have also seen the relative performance of small versus large cap stocks correlate with the movement of stocks based upon their probability of default. Rising relative small cap leverage is a broad-based phenomenon, as 9 of 11 S&P 600 sectors have higher debt-to-EBITDA1 levels than their S&P 500 peers.
As we move further along in the current economic cycle and bull market, we look for opportunities to improve the quality of our investments. Historically, small cap stocks have been more volatile than large stocks, as measured by their standard deviation of returns. For the reasons cited above, we are trimming our position in US small cap stocks at the present time.