Welcome to RBC’s Markets in Motion podcast recorded October 24th, 2022. I’m Lori Calvasina, head of US equity strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. In this edition of the podcast, we reflect on hot topics and some of the most interesting things we saw and heard last week. Three big things you need to know: First, we received several questions about how Small Caps look from a balance sheet perspective. The short answer is: worse than Large Cap given shorter maturities and less exposure to fixed rate debt. This is admittedly a risk to our Small Cap overweight, but we are sticking with our call. Second, beat rates and EPS growth expectations have continued to soften now that 3Q22 reporting season is in full swing, as has the tone in company commentary. Third, midterm election developments continue to trend in a stock market friendly way. Republicans have pulled well head of Democrats in the generic Congressional ballot and are also now expected to take the Senate in betting markets.
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Takeaway #1: Last week, we received several questions about how Small Caps look from a balance sheet perspective. The short answer is: worse than Large Cap.
- In terms of the stats, the weighted average maturity for Russell 2000 companies is 4.8 years vs. 8.8 years for large caps.
- Additionally, there’s less fixed rate debt in small cap (a little under 50%) than large cap (a little over 60%). That being said, it’s worth noting that the percent of fixed rate debt stabilized in small cap, ticked up a little bit over the past few years.
- This is an issue investors are right to worry about. Worse balance sheets usually continue to the underperformance that small caps see during or right after Fed tightening cycles. There is one key exception to this rule, though. It’s the tightening around the tech bubble period when Small Caps actually outperformed and went on to outperform for an extended period after. Similar to today small caps experienced an extended period of underperformance heading in, there was a big pull forward in spending that inflated the large cap growth stocks and small caps were deeply discounted relative to Large Caps in terms of valuation.
- Overall, we see balance sheets as a risk to our Small Cap overweight, but we are sticking with our call.
Moving on to takeaway #2: the earnings story is softening now that 3Q22 reporting season is in full swing.
- The percent of companies beating consensus on EPS is tracking at 77% – trending lower compared to prior quarters.
- Additionally, 2023 EPS bottom up consensus is tracking at $237 – slipping but not sliding yet.
- There’s also been a softening company commentary, but not quite a slide. Key themes discussed by companies so far include ongoing evidence of consumer resiliency, the characterization of inflation / labor / supply chains as problems that are/will remain intense but are getting better, some caution on hiring, an unwillingness to speak directly on 2023 yet alongside contingency planning for a worsening macro backdrop, the significant bites that the stronger US Dollar have taken out of EPS from some companies including those in tech and materials, and the tough backdrop in Europe alongside the idea that the US is much more resilient.
Wrapping up with takeaway #3: midterm developments continue to trend in a stock market friendly way.
- One of the biggest things that jumped out in our high frequency indicators last week is that betting markets are now expecting the Republicans to win both the Senate and the House. While the Republicans had been gaining ground in the betting markets in the Senate race, it has only been over the past week that the Republicans have pulled decisively ahead.
- This syncs up with trends we’ve been discussing in the generic Congressional ballot polling data over the past few weeks, which is also now tracking strongly in favor of Republicans.
- This shift comes as inflation and the economy are back on top as the most relevant issues to voters in various polls that have been coming in.
- We continue to see the midterms as a positive catalyst for the stock market, should Republicans take back control of at least one chamber, given the tendency of the stock market to rally in the 4th quarter of midterm years – starting around now a few weeks before the contest, a history of strong gains when Democrats control the White House and Republicans control one or both chambers of Congress, and extremely low levels of consumer sentiment among Republicans which may improve after the mid terms of Republicans do indeed do well.
That’s all for now. Thanks for listening. And be sure to check out our sister podcast, RBC’s industries in motion, for thoughts on specific sectors from RBC’s team of industry analysts.