There is a vociferous debate going on right now about whether and to what extent small caps can continue to outperform going forward.
Needless to say, this is tied up with the trade war discussion. Small cap outperformance in 2018 has generally been attributed to the assumption that less international revenue exposure (relative to large caps) inoculates them against further escalations on the trade front.
As you can see from that visual, U.S. small caps’ outperformance versus global equities has come off a bit from the highs recently, and the idea that they’re immune to the trade war was called into question last month by Morgan Stanley and also by Barclays.
“Recently, US small caps have been the safe haven of choice over the S&P 500 as investors view them as less vulnerable to rising trade tensions [and] while this makes sense intuitively, we are skeptical that US-centric small cap companies would be immune to a major escalation in trade tensions, which would ultimately be a significant drag on the US economy, too”, Morgan Stanley wrote on July 9, in the same note that found the bank’s Michael Wilson delivering the tech downgrade that won him plaudits in the media last week, amid the FANG+ correction.
“What really matters for estimating the impact of tariffs are the actual imports and exports and margins”, Barclays said, in a lengthy piece throwing cold water on the idea that small caps can continue to outperform.
For those interested in this debate, BofAML’s Jill Carey Hall and Savita Subramanian have re-launched their small cap strategy research and they’re “cautious” for a long list of reasons, one of which recalls some of my random musings from a July 8 post, in which I said this (and do note that I always try to play down these “predictions” because they’re not really “predictions”, they’re just me calling it like I see it at any given time):
On small caps, I’d be careful there. The investment case seems to be predicated almost entirely on assumed insulation from the trade conflict, which means you could get underperformance if trade tensions fade, and if they don’t (i.e., if trade frictions get worse), you could discover that whatever safety goes along with being in U.S. small caps was already priced in.
Well, here’s BofAML saying essentially the same thing, in the course of detailing how “both binary outcomes on trade tensions pose a risk to small caps.”
If trade tensions ease such that we avoid a trade war, we would expect large cap multinationals that sold off to rebound. In this scenario, interest rates are likely to continue to rise amidst healthy economic growth, a risk for small caps.
If trade tensions worsen, resulting in a trade war and hurting economic growth, we would expect small caps to underperform in a risk-off environment. Small caps are not immune to a trade war or a global growth slowdown given many are suppliers to many large cap multinationals. Trade risks appear priced in everywhere except for small caps (Chart 4)–the only segment of the market to see multiple expansion since mid-February.
Hall and Subramanian go on to talk about seasonality and technicals and also note that strong top and bottom line growth should mean that on an absolute return basis, things should generally be fine. In other words, from their perspective this is about relative performance vis-à-vis large caps, not necessarily a bearish call.
That said, they do flag one big risk to small caps (i.e., one potentially dangerous dynamic that could be overtly bearish): record leverage. The following color and visuals aren’t what one might call “comforting”:
Small caps have thrived on cheap access to capital, where the leverage ratio for nonFinancials (based on Net Debt/EBITDA) of 3.5x is near all-time highs, vs. large caps’ ratio of 1.9x which is in-line with history (Chart 14). Excluding Tech, small caps’ leverage ratio is a whopping 3.8x (12% below historical peak), vs. 2.6x for large caps (19% below historical peak). Small cap leverage usually peaks during recessions, not before. For the median small cap company, interest coverage is near all-time lows.
If you think you’ve heard that before, it’s because you have – from SocGen and specifically, from the bank’s Andrew Lapthorne. “Small cap issues haven’t been resolved,” the bank recently wrote, before reminding you that while the group has outperformed “on the back of accruing benefits from the tax reform and relative safety amid trade war fears, the Fed is still raising rates, which is likely to increase pressure on the bottom lines of highly levered negative-cash-flow-generating companies.”
Here’s a look at the trend in the percentage of Russell 2000 companies with negative earnings:
In that context, what Hall and Subramanian say about small caps’ debt profile is notable. “Small caps have a much higher proportion of floating-rate debt than large caps and shorter average debt maturity, which makes them more sensitive to rising rates and widening credit spreads”, they write.
Again, the bank doesn’t paint a particularly dire picture for the space. Rather, this is simply about relative performance and the extent to which whatever “safe” haven status investors were willing to afford to small caps amid the trade tensions isn’t likely to shield them going forward relative to large caps no matter what happens on the trade front.
You can take all of this for what it’s worth, but what I would gently suggest is that the leverage issue is indeed something to be at least marginally concerned about (get it? “margin”ally). This is a highly leveraged space in a rising rates environment with a lot of exposure to floating rate obligations. So you know, adjust your expectations accordingly.