Analysts make the case for US small- and mid-caps while waiting for the Fed to call an end to its hiking cycle
What does 2024 have in store for global markets? JP Morgan’s outlook for the year sees “2% growth, zero recessions, 2% inflation and 4% unemployment” in the US. Will its forecasts come true? Or is it just reading the tea leaves — an act of divination?
JP Morgan suggests a soft landing for the US remains in reach, with disinflation set to continue. According to the bank, the US Federal Reserve Board now appears satisfied with its progress — an about-face from this year’s white-knuckle warnings.
This time last year, our outlook cover story (A tougher year ahead, issue 1069, Jan 16, 2023) reflected the market’s jitters, with analysts weighing the possibility of recessions in major economies.
However, 2023 defied almost everyone’s expectations, says Candace Browning, head of Bank of America (BofA) global research. “[2023 saw] recessions that never came, rate cuts that didn’t materialise, bond markets that didn’t bounce — except in short-lived, vicious spurts — and rising equities that pained most investors who remained cautiously underweight.”
This year, analysts are abuzz about a global shift to impending rate cuts. The Fed decided on Dec 13 to keep its key interest rate steady for the third straight time as policymakers on the Federal Open Market Committee (FOMC) voted unanimously to keep the benchmark overnight borrowing rate between 5.25% and 5.50%.
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With US inflation held down, members indicated at least three quarter-point rate cuts this year — and more critically, a willingness to do so pre-emptively.
This could potentially signal the end of a cycle that has seen 11 hikes, pushing the Fed funds target rate to a 22-year high. Further cuts could reduce this rate to 2% and 2.25% sometime in 2026.
“We expect 2024 to be the year when central banks can successfully orchestrate a soft landing, though [we] recognise that downside risks may outnumber the upside ones,” says BofA’s Browning.
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Analysts from the US’s largest banks agree that rate cuts are coming but not until the latter half of the year.
“A decelerating economy should keep the Fed firmly on hold through the first half of 2024,” reads JP Morgan Asset Management’s outlook. “Assuming the economy avoids a recession next year, we expect the Fed to reduce policy rates gradually and avoid a knee-jerk pivot to aggressive rate cuts.”
The current target range is 5.25%–5.50%. JP Morgan’s head of research for commercial banking forecasts 25 basis point (bps) cuts at each FOMC meeting starting in June, bringing the target range to 4%–4.25% at the end of 2024.
Similarly, BofA’s head of US economics expects the first Fed rate cut in June but with a slower 25 bps cut per quarter in 2H2024 (September and December).
Morgan Stanley, meanwhile, expects the Fed to start cutting in June and end the year with rates at 4.375%, or within the target range of 4.25%–4.50%.
The FOMC holds eight regularly scheduled meetings per year. Following this year’s June meeting, the FOMC will meet four times in 2H2024 — in July, September, November and December.'
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Jerome Powell, chairman of the US Federal Reserve, departs from the news conference following a Federal Open Market Committee (FOMC) meeting in Washington DC on Dec 13, 2023
Inflation will gradually move lower across the globe, allowing many central banks to cut rates in 2H2024 and avoid a global recession, according to Claudio Irigoyen, BofA’s head of global economics.
Over at Citi, the bank’s bullish “slow then grow” thesis sees slower economic activity in early 2024 but with no synchronised recession, followed by an economic acceleration later this year.
“Even as the job market cools, we see corporate profits rising from 2023 to 2024 at a 5.0% rate and then at a 7.0% rate from 2024 to 2025,” says David Bailin, chief investment officer at Citi Global Wealth.
Bailin expects the Fed to lower rates “at the short end” as it sees employment impacted negatively by the lagged effects of tightening. “If unemployment rises more quickly than expected, the Fed will also react faster by lowering rates more quickly. We see inflation running at 2.5% by the end of 2024 and 10-year rates in a range of 3.5%–4.0% at that time.”
Citi forecasts a return to form for the global markets after “three distinct phases of market activity” since the start of the pandemic.
The first was a period of stimulus-driven euphoria from 2020–2021. During this period, low emergency rates plus broad support for the economy led to excessive and unsustainable market returns, says Citi.
The second phase was a period of bear market caution in 2022–2023. The Fed’s higher rates and quantitative tightening crushed bonds and equities but not the economy, adds Citi.
For this year and next, it will be a period of normalisation and growth, according to Citi. “We are exiting a period of rolling sector recessions and unusual levels of employment demand to begin a global economic recovery led by the US.
Time to look at US small-caps?
In 2022, the S&P 500 slid close to 20% in the wake of the Fed’s decision to rapidly hike interest rates. However, equity markets advanced in 2023, recovering some lost ground as the S&P 500 boasted double-digit returns.
As at Dec 29 — the last trading day of 2023 — the S&P 500 had risen 24.73% over the year to 4,769.83.
Morgan Stanley expects US earnings growth to trough in early 2024 and rebound thereafter, with the S&P 500 reaching 4,200 in June and ending the year at 4,500. “In the short term, we expect the earnings recession to continue … We continue to recommend a defensive growth and late-cycle cyclical [stocks through a] barbell strategy and look for a durable earnings recovery to emerge during 2024.”
BofA, meanwhile, is much more bullish. Its head of US equity and quantitative strategy Savita Subramanian thinks the S&P 500 will end the year at 5,000, an all-time high.
Subramanian remains bullish on equities not because of expected rate cuts “but because of what the Fed has already done and how corporates have adapted”. “Earnings per share (EPS) can and has accelerated as GDP slows, and reshoring has been identified as a tailwind by companies.”
US equities gained 20.0% in 2023 through late November, with the market focused on a short list of artificial intelligence-led tech names.
After a three-quarter profit recession ending in 2Q2023, Citi expects final profits for 2023 to be up 0.9%. “We look for corporate earnings to grow by 5.1% in 2024 and 6.8% in 2025.”
Thanks to the “Magnificent Seven” — Amazon.com, Apple, Google parent Alphabet, Meta Platforms, Microsoft, Nvidia and Tesla — the largest US tech-related shares drove the majority of global equity returns last year.
However, Citi believes this is unlikely to continue into 2024 and 2025. “For 2024, we expect profitable small- and mid-cap growth shares with solid balance sheets will see renewed interest and there are other potential well-valued equity opportunities globally,” says CIO Bailin.
Citi points to a “wide valuation gap” between the market-cap-weighted S&P 500 and small- and mid-cap (SMID) stocks. These stocks, which carry less debt in their capital structures, should benefit from earnings growth and narrowing valuation gaps.
According to Citi, SMID stocks boast the faster growth of small companies and higher quality of mid-sized firms. Thus, investors can gain access to a more resilient and less volatile collection of growing stocks.
In the US, the most-used SMID-cap benchmark is the Russell 2000 Index, which straddles all the stocks in the small-cap (S&P 600) and mid-cap (S&P 400) space. As at Dec 29, the Russell 2000 index is up 15.78% over the year.
As of Nov 30, 2023, the top 10 index constituents are Super Micro Computer, Light & Wonder, Rambus, Simpson Manufacturing, Bellring Brands, Immunogen, Onto Innovation, Qualys, Comfort Systems USA and Chord Energy.
Chris Hyzy, CIO for Merrill and BofA Private Bank, agrees that lesser-known names might soon have their day in the sun. “The equity markets, which were led by a very narrow group of companies in 2023, should broaden out, with other sectors — perhaps including small-cap stocks and even emerging markets — beginning to participate more in the gains.”
However, this gradual expansion will likely take all of 2024, he adds.
Mid-caps might be more secure if the market slows, according to Fidelity International’s global head of multi-asset investment management Matthew Quaife. “We think mid-cap stocks look attractive along with much of the S&P 500 that have not shared the incredible performance this year of the ‘Magnificent Seven’ technology stocks. Valuations look reasonable for these well-run companies with solid growth prospects.”
In contrast, US small-caps would be more challenged in a slowdown or recession scenario given their greater debt refinancing needs, adds Quaife. “But for now, we think the momentum in global equities is likely to remain positive as the scope and breadth of the ongoing rally broadens.”
Large-caps still high-quality
Analysts at JP Morgan are less exuberant on all fronts, cautioning that while 2023 was a “surprisingly strong year” for the US equity markets, investors should temper their expectations for 2024.
Street expectations show EPS growing by 11% next year, double the long-term average, while JP Morgan’s models estimate a more conservative 5%-6% growth. “Estimates for profit growth look lofty, volatility has been unusually low, valuations could come under further pressure and economic growth is likely to slow.”
Furthermore, the top 10 stocks on the S&P 500 are 38% more expensive relative to their 25-year averages, compared to just 14% for the rest of the index. Overall, the S&P 500 is about 17% more expensive.
However, valuations since the Global Financial Crisis have been unencumbered by high rates, notes JP Morgan. “Looking at forward P/E ratios over the last 25 years, today’s real interest rate implies that stocks are 30% overvalued. We don’t expect a massive imminent correction while profits are still growing, but valuations may need to reset over time in a higher-for-longer rate environment.”
Contrary to Citi’s small-cap thesis, JP Morgan continues to favour the “quality exhibited in large-caps”.
“Small caps have seen a significant valuation reset, but are levered to domestic growth, which could slow. Furthermore, margin pressures could be particularly acute even if input and wage costs are slowing, as 38% of outstanding debt for small caps is [on a] floating rate [basis], raising concerns that higher rates could result in more immediate pressure.”
With “significant divergence” within sectors and industries, JP Morgan advises investors to look for quality stocks over growth and value. “Stretched valuations and overly optimistic earnings projections, coupled with a slowing economy, mean US stock investors should look toward profitability in large-cap names. This favours an allocation to quality regardless of sector and underscores the importance of security selection.”
Photos: Bloomberg
