abrdn US Small Cap Quarterly Update podcast: Q2

Tim Skiendzielewski, Investment Director with the North American Equities Team here at abrdn. Tim will discuss what the landscape for small caps look like currently, and touch on expectations for the asset class moving forward. 

Transcript

Joe Summers:              Hi, and thank you for listening to the abrdn US Small Cap Quarterly Update Podcast. My name is Joe Summers [PH] and I'm an Advisor Consultant here at abrdn. Joining us today is Tim Skiendzielewski, Investment Director with the North American Equities Team here at abrdn. Tim will discuss what the landscape for small caps look like currently, and touch on expectations for the asset class moving forward. Tim thanks for joining.

Tim Skiendzielewski:   Great, thanks so much, Joe. Glad to be here.

Joe Summers:              Absolutely. Now, let’s hop right into it Tim, could you provide us with a recap of what you saw in the markets in the small cap asset class during the first quarter?

Tim Skiendzielewski:   Sure. Well, it's definitely another interesting quarter, to say the least. To be honest, after the very strong move we saw in the equity markets in the fourth quarter, we weren't really sure what to expect as we enter 2021. But if you really pressed me back to the beginning of January, I probably would have said that the Russell 2000 would give back some performance after that very strong 32% move at the end of last year. But lo and behold, the market continued to move higher each month this year, when all was said and done. The Russell 2000 finished up just under 13% and importantly, it just about double the return of the S&P 500.

Now obviously, from a macro perspective, I think there was clearly a continuation of the reopening trade and we saw vaccine progress that started in the fourth quarter continuing into this year. I think that caused investors to price in and improving economic outlook. Really, despite some choppy economic indicators, GDP forecast very importantly have started to rise. Again, driven by this more bullish views on the pace of the reopening.

In addition to all that you had -- there has been this obvious excitement around the announcement of this massive stimulus bill which I'm sure we'll get into. But all of that led to the many of the trends that we saw to close out last year continuing to the first quarter mainly kind of value bested growth, aided by the steepening yield curve. Cyclicals did very well, the more highly levered companies outperform and smaller firms outpaced larger ones. All in all, a very strong start to the year for equity markets in particular for small caps.

Joe Summers:              That’s great Tim. The markets have clearly been reacting to the infrastructure plan put forward by President Biden. What are the practical implications for the equity markets?

Tim Skiendzielewski:   Yeah, honestly, I think much remains to be seen, I mean, on its face the first tranche is roughly two and a half trillion in spending over 10 years, and that will be financed by various corporate and consumer tax increases. Then this will be followed up by a bill focused on social infrastructure investment and total spend could be upwards of 4 billion, healthy number to be sure. But obviously knowing what we know about the current political climate, it's hardly -- it's unlikely to garner much, if any bipartisan support given that focus on tax increases, as well as some of these nontraditional infrastructure investments, which I think has caused some consternation in the Republican Party.

There may be tweaks to the ultimate size and more likely how it’s funded. That being said it will go through in some form or fashion and a large portion of the proposed bill is going to go towards green initiatives. Tax credits for carbon capture, investments in renewables and green energy use, electric vehicle infrastructure, things like that. So there's going to be a clear benefit, I think, to the newer industrial economy and certain technology companies that are exposed to EV adoption and greener areas of the economy. Also, I think certain sub sectors within the material sector could benefit. We've already seen these areas get bid off as the infrastructure bill has gained steam.

On the other hand, you have these expectations for higher growth and potential overheating of the economy on the back of all this spending has driven up inflation expectations, and this has really hurt the tech and healthcare which are both sectors with longer tailed growth expectation, and these are areas that are hurt by higher interest rates. Also, utilities and consumer staples have historically had a negative relationship with inflation expectations. But by and large value oriented sectors such as energy communication services, and financials tend to outperform when these inflation expectations are rising. There will be nuances in terms of sector and factor returns, though overall, I think, higher growth expectations are undoubtedly a positive for small caps, given small caps have greater leverage to the domestic economy.

Joe Summers:              And Tim, you mentioned that tax increases will fund much of these infrastructure investments, what impact will they have on equities and small caps specifically?

Tim Skiendzielewski:   Yeah, it's a good question and one we're spending a lot of time on, and I think a lot of investors are spending a lot of time on. The initial proposal has the corporate tax rate rising from 21% to 28% along with some other proposals, like potentially limiting inversions and increasing the global minimum corporate tax rate. Again, there's likely to be strong Republican opposition. A compromise has already been floated of around a 25% corporate tax rate, which is obviously -- 20, I'm sorry, 25% corporate tax rate, which is obviously higher than 21%, currently, but still much lower than the 35% that was in place prior to the Tax Cut and Jobs Act of 2017.

We tend to be of the view that while higher taxes are clearly a risk to earnings growth going forward. We think this risk is at least partially reflected in share prices at this point, given how long investors have had to focus on the issue. Recall that President Trump's tax cuts that I just referenced helped drive stocks higher in 2018 and 2019. With companies with the biggest effective tax rate declines faring the best now that has gone the other way with companies that will see the largest effective tax rate increases have actually underperformed.

It is notable for small caps as you mentioned, since these are more domestically focused businesses, they saw a bigger reduction in tax rates post tax reform and us now stand to see greater increases. This is most notable financials and consumer discretionary sectors. But by and large, we think there's enough pent up demand in the economy that companies will still be able to perform well and drive earnings growth even in the face of higher taxes.

Joe Summers:              You mentioned value continuing to do well relative to growth, Tim. Do you think that continues?

Tim Skiendzielewski:   Tough to say after what seemed like a decade about performance of growth over value. We saw a value renaissance in the fourth quarter with a lot of this excitement around the reopening and more cyclical areas of the market leading the charge. That continued into the first quarter, as I mentioned, as inflation expectations and thus interest rates rose, it makes sense that it might continue. We have higher stimulus leads to higher GDP growth leads to higher inflation expectations lead to higher interest rates. This would all argue for continued value outperformance.

But then the other thing the other side of the coin that we consider is that we've seen this multi year, so called passing of the baton from old world economy to new world economy with firm, long tailed structural drivers from any technology and services companies. To just give you a few examples, there's been massive amounts of biotech funding that hasn't slowed down over the past couple of years. Demand for software has been very strong as companies across industries look to undergo what are called digital transformations, semiconductor content is exploding led by auto and industrial applications.

And then finally, there's really lots of new interesting areas within consumer discretionary as Omnichannel retailing expands. There, again, there's these very clear long tailed structural drivers in place for many growth sectors that we really don't see abating anytime soon, which we argue for maybe continued outperformance of the growth style, I think we're still firmly of the view that quality growth companies will continue out to perform over a multiyear cycle, albeit you may see more balanced returns between the two styles.

Joe Summers:              Lastly, what are your thoughts on the outlook for small caps for the balance of the year and into 2022?

Tim Skiendzielewski:   Yeah, well, I'll caveat what I'm about to say with as we've come to understand, over the past 13 months, we should probably expect the unexpected. That said, should vaccination progress continue, we continue to be pretty constructive about the small cap asset class. First and foremost, the economy is continuing to strengthen not just here in the US, but globally as well, and that's a very important first condition. What does that lead to in terms of earnings growth? Now current consensus expectations anticipate that 2021 earnings will rebound above 2019 levels with the second quarter expected to be the peak. Importantly, growth is accelerating for small caps more than large CAP. Rough numbers are that small caps could grow earnings 16% in 2021 and 21% in 2022 and that compares to 11% and 14%, for large caps respectively. Better earnings growth for small caps, I think very important.

The other thing that we look at is M&A activity, M&A activity as heated up, which tends to be a good sign for valuations. While valuations have expanded on an absolute basis, we really don't think they're egregious for the level of earnings growth expected over the next several years. Then again, on a relative basis, if you compare small caps valuations relative to large caps, we still think they're very attractive. So all tolled, we think there can be continued upside to the asset class, so probably best to think of it more likely more measured than we've seen in recent quarters.

Joe Summers:              All great information Tim. As always, thank you for your keen insights on the small cap market. Thank you all for joining us on today's update podcast. We look forward to doing more of these podcasts moving forward each quarter. If you have any questions for us in the meantime, please don't hesitate to reach out at 866-667-9231 and thank you for joining us on today's abrdn US Small Cap Quarterly Update podcast.

IMPORTANT INFORMATION:

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially. 

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