While value stocks and small caps have been predicted to emerge as market darlings in 2024, investment executives say renewed concerns of an economic slowdown could complicate this outlook.
The last week of July showed initial signs for optimism, with the Bank of England cutting rates for the first time since 2020, and Australia and the US reporting cooling inflation figures.
However, share markets were in the red by Friday as fresh economic signals from the US stoked investor fears that central banks “might have left it too late”, according to AMP’s chief economist, Shane Oliver.
“There’s renewed fears about economic growth,” he told InvestorDaily.
“While our share market celebrated lower-than-feared inflation on Wednesday [following the latest inflation data], and kept going higher on Thursday, those gains have been largely reversed because of the poor signal from global share markets.
“There was initially that rotation from tech into other parts of the market, but I guess investors are now worried [that] these other, more cyclical parts of the market, like small caps, could be vulnerable if growth does slow down too much.”
Overnight, the Russell 2000 was down 3 per cent as of Friday AEST, he noted, while the Dow Jones fell 2.1 per cent.
The ASX also posted its worst daily performance in almost 18 months, tumbling 2 per cent by close of trading on Friday, 2 August.
Characterising these moves as a “growth scare” in a typically weaker season for markets across August and September, Oliver conceded increasing geopolitical risks emerging from the US election and events of the Middle East raise concerns that this market correction “could go on a little bit longer”.
Looking at the outlook for small caps, which seemed poised to benefit from interest rate cuts over the course of 2024, Oliver maintained much would be determined on whether global markets, including the US and Australia, are able to navigate a soft landing.
“In the past, rotations can keep share markets going for a little bit longer, it ultimately depends on whether we get a recession or not,” he said.
“My best case is we avoid a recession, and therefore, the rotation will help markets, even though tech has started to take a bit of a backslip. But I have to say, I’m feeling nervous about it because the things that people were talking about regarding a recession two years ago are still there.”
The yield curve in the US and in Australia remains inverted, he explained, while the US leading indicator has fallen nearly two years in a row, and more recently, there has been “bleak” jobs indicators coming out of the US.
“Growth concerns would swamp any rotation in the short-term, but hopefully, if we avoid a recession – which I think we probably will, but it’s something I’m still concerned about – then the rotation will start up again,” Oliver added.
Interpreting signals
Joe Unwin, head of portfolio management at Apostle Funds Management, explained markets appear spooked by early signs of a slowdown in economic activity, with Australia’s share markets having taken on a lot of that negative sentiment into trading.
This could potentially translate into flows to small caps, at least in the short term, as people seek to sell growth stocks, he said, although the question remains “whether the negative returns in these growth stocks are offset by positive returns in small caps or value stocks”.
“I would suspect buying in these small caps would be done a little bit more value-consciously than it was in the growth stocks, so if markets are correct and there is a growth slowdown, you won’t necessarily see a large rally in these small caps or value stocks. You’ll certainly see a lot of outperformances relative to growth stocks, but they may have a more modest return than you’d expect in a rally,” he told InvestorDaily.
On the contrary, if growth data ends up being “not too bad”, then buying interest could translate into a strong rally for small caps.
“But I suspect it would be a lot less sharp than you’d see in the growth space,” Unwin said.
“It’s probably more like a medium-term period of good returns than a short period of really high returns.”
Like Oliver, the investment executive believes markets will be closely watching the US Federal Reserve’s next move and could be waiting for a “green light”.
“I think, looking at the data last night, it’s given people confidence that, if anything, the Fed might’ve kept rates high for longer than they should’ve and that they will almost certainly start cutting rates – which is sort of a green light for these small cap stocks,” Unwin said.
Ultimately, he continued, a lot of investor sentiment will boil down to whether interest rate cuts are being driven by inflation or growth concerns. The former could prove promising for growth stocks, indicating lower inflation, while the latter could set the stage for value and small caps.
“Typically, rate cuts would be good for growth stocks, but you could argue they’ve already priced in rate cuts. Rates coming down because of an economic slowdown is bad for investor sentiment, and really, growth stocks are priced based on good investor sentiment,” he said.
“As soon as investors start to get nervous, those stocks that are priced really highly have a long way to fall if that optimism disappears, whereas small caps are being priced with little optimism. They’re priced conservatively, so they would fare much better when rates start coming down.”
