Welcome to RBC’s Markets in Motion podcast, recorded May 31st, 2023. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers. Today’s podcast is part 2 of our deep dive into our outlook for the US equity market, in which we discuss our thoughts on key positioning trades. Three big things you need to know:
- First, we think the case against US equities relative to non-US equities has been overstated.
- Second, we think the risk of a pause in Large Cap Growth leadership has grown, even though we think this part of the market has outperformed for good reasons, and
- Third, we think Small Caps are at an attractive entry point for patient investors.
If you’d like to hear more, here’s another six minutes.
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While you’re waiting, a quick reminder that if you’ve found our work helpful, we’d appreciate your vote in the Institutional Investor All America Research Survey in the Portfolio Strategy category. Voting is open now and expected to remain open through June 23rd.
Now, the details.
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Starting with takeaway #1: The Case Against US Equities From A Geographical Perspective Seems Overstated.
- In our work, some of the things that stand out to us on this point are:
- First, US equity valuations have improved relative to non-US equities. This is one of the most frequent complaints we hear about US equities.
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- But the US has moved well below peak relative valuation vs. non-US and has gotten close to its long-term average vs. Europe.
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- In terms of sectors, Tech and Staples look overvalued in the US vs. their European counterparts, but many other sectors actually look reasonably valued or undervalued in the US.
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- Second, global investors may have been too pessimistic on the US economy. On this point, it’s worth noting that economic surprises are trending better in the US than Europe.
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- Third, the flow rotation story for Europe hasn’t held up. While US equity outflows persist, the inflows to European focused equity funds seen to start the year have faded and China inflows are slipping from peak.
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Moving on to takeaway #2: The Large Cap Growth Leadership Trade Has Been Deserved, But Is Looking Stretched
- The R1000 Growth index has powerfully outperformed the R1000 Value index this year, benefiting from the pre-trade of the Fed pause, the regional banking crisis, strong earnings…
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- AI, and most recently the debt ceiling drama which usually hits value and cyclical sectors the hardest.
We suspect Large Cap Growth leadership will take a breather before the year is up, but think the move has been deserved and may not be over just yet.
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Here are the advantages we see for Growth right now:
- Growth has been much stronger than Value on earnings, with a greater rate of upward revisions.
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- Interest rates are expected to come down a bit at the end of this year and next, and growth typically outperforms when that happens.
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- GDP is expected to be sluggish for a while with 2024 expected to come in at 0.8%. Historically, Growth outperforms Value when real GDP is below its long-term average of ~2%.
That being said, here’s what’s worrying us about the Large Cap Growth trade right now, besides the possibility that the debt ceiling will spark rotation back into cyclicals and Value:
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- Growth looks crowded. Asset manager net long positioning for Nasdaq 100 mini’s has hit the high end of its recent range, per data from CFTC.
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- Growth looks expensive. The ratio of the Russell 1000 Growth P/E relative to the Russell 1000 P/E is back to the levels that have marked the peak of the past few years.
Tactically it’s tough to say what sparks this shift, but conditions seem ripe.
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Wrapping up with takeaway #3: Small Caps Are At An Attractive Entry Point For Patient Investors and we are sticking with our overweight on Small Caps.
- Small Caps have been attempting to stabilize relative to Large Caps, with the ratio of the Russell 2000 relative to the S&P 500 trading sideways near its 2020 low.
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- Aside from general economic angst and the stubborn dominance of Large Cap growth, there’s one big problem we see for Small Caps right now -
- Large Caps have a better earnings profile. Specifically, the rate of upward EPS estimate revisions has been much stronger for the S&P 500 than the R2000 this year – a reversal of 2022 when the Russell 2000 was stronger.
- But list of things that intrigue us with Small Caps is much longer:
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- First, Small Caps have been deeply out of favor and positioning is starting to improve. We see this on CFTC’s data for both asset managers and leveraged funds.
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- Second, Small Caps are deeply undervalued. The Russell 2000’s P/E has been around 13.8x in May – well below average –
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- and Small Caps are also deeply undervalued vs. Large Caps, at levels bordering on the late 1990’s/early 2000’s.
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- Most sectors also look cheap in Small Cap relative to Large Cap.
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- Third, periods of economic stress are usually good buying opportunities for Small Caps. Typically, Small Caps underperform heading into a recession and start to outperform mid way through.
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- Similarly, Small Cap outperformance also tends to begin around peak tightening in C&I lending standards….
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- …as well as when the unemployment rate starts to pick up.
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- Fourth, Small Caps tend to outperform during easing cycles, which investors are anticipating for 2024.
That’s all for now. If you missed it, please check out part 1 of this podcast for updates on our S&P 500 price target and EPS forecasts. Thanks for listening, and be sure to reach out to your RBC representative with any questions.