The current US inflationary environment has weighed on the economic outlook. This bout of inflation, which began amid pandemic-induced supply-chain bottlenecks, has persisted even as Covid pressures have begun to show signs of slowing. And it’s only gotten worse as the war in Ukraine has escalated.

However, we believe that US investors need not panic. In spite of the complicated market backdrop, we see opportunities in small-cap equities for those who are able to tune out the noise and focus on quality.

Small caps face different risks than large during times of inflation

Compared to large caps, how should we expect small-cap equities to perform in periods of higher inflation?

On one hand, small-cap equities present greater risks than large caps during times of inflation. This is because smaller companies may have a harder time than their larger peers absorbing higher expenses. And smaller companies are often more labor intensive than large ones, so if the higher costs of labor continue to play a role in this current period of higher inflation, small-cap profits could be at risk. These risks are especially applicable to smaller companies with less-diverse supply chains or those that are more exposed to input or commodities costs.

However, we believe that when it comes to small caps and inflation, there are plenty of reasons not to throw the proverbial baby out with the bathwater. In fact, there are historical examples of small caps performing relatively well in times of heightened inflation.

Keeping current inflation in context compared to the 1970s…

The current inflationary environment, which has seen gas prices (among others) jump, may call to mind the last period of significant inflation in American history — the 1970s. During this time, despite the risks associated with small caps in periods of high inflation, they outperformed their larger peers.¹

High inflation in the 1970s came about because in the years prior, policy had been too loose for too long. And it was made worse when the economy was hit with an energy shock in the form of an embargo from the Organization of Arab Petroleum Exporting Countries (OAPEC). In response, the US Federal Reserve (Fed) had to carry out significant policy tightening (namely, raising interest rates significantly) in order to bring inflation back down.

Similarly, the current inflationary period also comes after a period of very supportive monetary policy. And, once again, we are in the midst of a period of rising inflation that’s gotten worse from an energy shock — this time in the form of the Russian invasion of Ukraine and the subsequent economic weaponry (i.e., sanctions) that Western nations have fired off in response.

But there are important differences between the inflation of the 1970s and the period we’re experiencing now:

In short, today’s inflationary challenges may turn out to look worse than they actually are. As supply-chain disruptions ease and the Fed’s actions take hold, there is, in our view, a very good chance that inflation cools.

…and the 2000s super cycle

While some investors are comparing the current inflationary environment to the 1970s, others may wonder how today’s commodities market stacks up compared to the last commodities super cycle in the 2000s.

That super cycle, or period of increasing commodities demand, was driven mostly by China and other emerging markets. And it coincided with a significant period of small-cap outperformance relative to large caps. During that time, WTI oil rose from $10.86³ per barrel in the late 1990s to a high of $145.31⁴ about ten years later — a 1,238% increase. During the same period, small-cap equities⁵ rose 87%, compared to large caps,⁶ which rose 23%.

So, while inflation can present greater risks for small caps than large, high inflation doesn't necessarily mean that small caps will underperform. In fact, as the below table illustrates, at heightened levels of inflation, there are multiple examples of small-cap equities outperforming large (+3.5% relative when the Consumer Price Index is greater than 4%).  

Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business, Jeffries.

Small caps and inflation today

High energy costs are a hallmark of the current inflationary environment. The war in Ukraine and subsequent sanctions against Russia have exacerbated inflationary pressures in this area and we suspect that this trend is likely to continue for the near term. This could damage demand as high energy costs eat into consumer spending activity.

But, on this front, it’s possible that small caps could benefit relative to their larger peers. Small caps tend to carry more weight than large caps to sectors that may benefit from higher energy prices (Table 2).

Source: abrdn, BPSS, Datastream, as of March 31, 2022. Small caps represented by the Russell 2000 Index. Large caps represented by the S&P 500 Index.

And not only does the small-cap universe have greater exposure to the sectors that could benefit from higher energy prices, but it also has lower exposure to consumer sectors, which are most likely to take a hit thanks to rising energy prices (Table 3).

Source: abrdn, BPSS, Datastream, as of March 31, 2022. Small caps represented by the Russell 2000 Index. Large caps represented by the S&P 500 Index.

Macroeconomic conditions that could support US small caps

There are other macroeconomic factors that bode well for US equity investors, too. Thanks to restrained spending during the pandemic, many US consumers have pretty healthy savings right now. This could help support consumption and growth even in the face of inflation, geopolitical instability and lower GDP forecasts.

Though we’ve revised our growth forecasts lower in light of the war in Ukraine and its myriad ripple effects, we still hold a positive outlook for the US economy as well as US small caps (Table 4). This asset class tends to be domestically oriented, so it could benefit from even a modest uptick in US growth.

Source: abrdn Research Institute, April 2022. “E” represents expectations.

We also think that in spite of inflation, services are likely to keep bouncing back as Covid restrictions ease throughout the country. The likely beneficiaries of this shift are better represented among US small caps than large.

Geopolitical risks with Russia, China and elsewhere may continue and increase in the coming months and years. It’s possible that globalization as we’ve known it in the 21st century has peaked in the US. If this is the case, US companies may look to invest domestically in areas including manufacturing and supply chains. This means that US smaller companies that fall along these supply chains or in these areas of manufacturing could benefit. This is especially true considering that we still expect capital spending to be strong in the coming years.

Quality: The key consideration in small-cap investing?

Fundamentals remain strong for US small caps. As do relative valuations. In fact, the valuation of small caps relative to large caps remains historically low.

Source: FactSet, Bloomberg, abrdn, March 31, 2022. Note: Excluding negative earnings. For illustrative purposes only. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially

And, as we’ve said before, we believe that there are often small-cap opportunities to be found, regardless of market environment, for investors who focus on quality. There are several important considerations when it comes to evaluating the quality of a company.

One is pricing power. Firms with pricing power are more likely to better handle rising input costs and avoid negative impacts on operating margins. Higher barriers to entry and elevated switching costs are two indicators of pricing power. A third is whether a given small company offers differentiated products and services.

There’s still room for niche companies to do well, even in inflationary environments or volatile markets, if their products and services are specialized enough. Other important elements of quality include balance-sheet strength and cash-flow generation.

Nearly one-third of the companies in the Russell 2000 Index, a proxy for the US small-cap equity market, are non-earners, or lower-quality firms that fail to demonstrate these characteristics. Low-quality companies may not have the financial wherewithal to manage their business in the face of more challenging macroeconomic conditions.

In particular, rising interest rates could threaten unprofitable, high-growth companies whose valuations have been supported by the low interest-rate environment that has persisted for the last decade or so.

Businesses characterized by elements of higher quality are more likely to be able to cope with higher inflation, ongoing supply-chain challenges and rising interest rates, even if they’re small. And within small caps, higher-quality companies are attractively priced compared to lower-quality companies.

Source: abrdn, Jefferies. As of March 31, 2022. Represents the valuation of the top quintile of the Russell 2000 ranked on return on equity (“Q1 ROE’” relative to the bottom quintile of the Russell 2000 ranked on return on equity (“Q5 ROE”).

So, the way we see it, smaller companies that fit the quality bill could have an edge over the balance of 2022 and beyond. While there are small-cap companies that meet these criteria across several sectors, we see great potential within technology and industrials, for example.

Within tech, many companies have high barriers to entry and sticky customer relationships. Software, in particular, could be attractive since it’s built into customer workflows and therefore is very difficult to replace. To a lesser extent, the same thing applies to semiconductors and related equipment. Semiconductors have been at the fore of the ongoing supply-chain disruptions, and capacity constraints have helped them with pricing power recently.

Certain areas of industrials also have attractive pricing power. These often come with a lag, but, generally, companies with differentiated products can help push higher prices onto consumers. The outlook for niche industrials with these unique products and limited competition could improve further as infrastructure investment increases. As this happens, they’ll be able to price for inflationary impacts.

The current market landscape is complicated. Inflation persists, interest-rates are on the rise and major geopolitical events, like the war in Ukraine, have thrown curveballs at a market that’s just emerging from a global pandemic and the attendant effects. But prudent investors can still find compelling opportunities among high-quality small-cap companies with durable business models and unique growth drivers — inflation or not.

US-080422-169083-1

The current US inflationary environment has weighed on the economic outlook. This bout of inflation, which began amid pandemic-induced supply-chain bottlenecks, has persisted even as Covid pressures have begun to show signs of slowing. And it’s only gotten worse as the war in Ukraine has escalated.

However, we believe that US investors need not panic. In spite of the complicated market backdrop, we see opportunities in small-cap equities for those who are able to tune out the noise and focus on quality.

Small caps face different risks than large during times of inflation

Compared to large caps, how should we expect small-cap equities to perform in periods of higher inflation?

On one hand, small-cap equities present greater risks than large caps during times of inflation. This is because smaller companies may have a harder time than their larger peers absorbing higher expenses. And smaller companies are often more labor intensive than large ones, so if the higher costs of labor continue to play a role in this current period of higher inflation, small-cap profits could be at risk. These risks are especially applicable to smaller companies with less-diverse supply chains or those that are more exposed to input or commodities costs.

However, we believe that when it comes to small caps and inflation, there are plenty of reasons not to throw the proverbial baby out with the bathwater. In fact, there are historical examples of small caps performing relatively well in times of heightened inflation.

Keeping current inflation in context compared to the 1970s…

The current inflationary environment, which has seen gas prices (among others) jump, may call to mind the last period of significant inflation in American history — the 1970s. During this time, despite the risks associated with small caps in periods of high inflation, they outperformed their larger peers.¹

High inflation in the 1970s came about because in the years prior, policy had been too loose for too long. And it was made worse when the economy was hit with an energy shock in the form of an embargo from the Organization of Arab Petroleum Exporting Countries (OAPEC). In response, the US Federal Reserve (Fed) had to carry out significant policy tightening (namely, raising interest rates significantly) in order to bring inflation back down.

Similarly, the current inflationary period also comes after a period of very supportive monetary policy. And, once again, we are in the midst of a period of rising inflation that’s gotten worse from an energy shock — this time in the form of the Russian invasion of Ukraine and the subsequent economic weaponry (i.e., sanctions) that Western nations have fired off in response.

But there are important differences between the inflation of the 1970s and the period we’re experiencing now:

• Central bank inflation targeting – Today, the Fed employs inflation targeting, a policy that involves adjusting monetary policy in order to create price stability, or control inflation levels. Inflation targeting is meant to help central banks respond effectively to shocks to the domestic economy. The Fed developed today’s inflation-targeting framework with the lessons of the 1960s-70s in mind.
• Long-term inflation expectations are anchored – In the 1970s,people lost faith in the Fed’s ability to bring inflation down, but today, most Americans don’t believe that high inflation will last long term. Survey data suggests that average inflation over the next five years is expected to be 3%2 — well below the spikes we’ve seen this year. These longer-term expectations make it easier for the Fed to react accordingly now.
• The Fed has a plan and is putting it to work – The Fed has responded to the current inflation situation, introducing the first of several planned interest-rate hikes in mid-March. And it’s plan is slow and steady, which gives the Fed a good chance to monitor the impact of past interest-rate hikes closely.
• We live in a global economy today – Right now, we’re still feeling the burn of global supply-chain disruptions that are the direct result of the Covid-19 pandemic. But these supply-chain issues will eventually work themselves out over time.

In short, today’s inflationary challenges may turn out to look worse than they actually are. As supply-chain disruptions ease and the Fed’s actions take hold, there is, in our view, a very good chance that inflation cools.

…and the 2000s super cycle

While some investors are comparing the current inflationary environment to the 1970s, others may wonder how today’s commodities market stacks up compared to the last commodities super cycle in the 2000s.

That super cycle, or period of increasing commodities demand, was driven mostly by China and other emerging markets. And it coincided with a significant period of small-cap outperformance relative to large caps. During that time, WTI oil rose from $10.86³ per barrel in the late 1990s to a high of $145.31⁴ about ten years later — a 1,238% increase. During the same period, small-cap equities⁵ rose 87%, compared to large caps,⁶ which rose 23%.

So, while inflation can present greater risks for small caps than large, high inflation doesn't necessarily mean that small caps will underperform. In fact, as the below table illustrates, at heightened levels of inflation, there are multiple examples of small-cap equities outperforming large (+3.5% relative when the Consumer Price Index is greater than 4%).

Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business, Jeffries.

Small caps and inflation today

High energy costs are a hallmark of the current inflationary environment. The war in Ukraine and subsequent sanctions against Russia have exacerbated inflationary pressures in this area and we suspect that this trend is likely to continue for the near term. This could damage demand as high energy costs eat into consumer spending activity.

But, on this front, it’s possible that small caps could benefit relative to their larger peers. Small caps tend to carry more weight than large caps to sectors that may benefit from higher energy prices (Table 2).

Source: abrdn, BPSS, Datastream, as of March 31, 2022. Small caps represented by the Russell 2000 Index. Large caps represented by the S&P 500 Index.

And not only does the small-cap universe have greater exposure to the sectors that could benefit from higher energy prices, but it also has lower exposure to consumer sectors, which are most likely to take a hit thanks to rising energy prices (Table 3).

Source: abrdn, BPSS, Datastream, as of March 31, 2022. Small caps represented by the Russell 2000 Index. Large caps represented by the S&P 500 Index.

Macroeconomic conditions that could support US small caps

There are other macroeconomic factors that bode well for US equity investors, too. Thanks to restrained spending during the pandemic, many US consumers have pretty healthy savings right now. This could help support consumption and growth even in the face of inflation, geopolitical instability and lower GDP forecasts.

Though we’ve revised our growth forecasts lower in light of the war in Ukraine and its myriad ripple effects, we still hold a positive outlook for the US economy as well as US small caps (Table 4). This asset class tends to be domestically oriented, so it could benefit from even a modest uptick in US growth.

Source: abrdn Research Institute, April 2022. “E” represents expectations.

We also think that in spite of inflation, services are likely to keep bouncing back as Covid restrictions ease throughout the country. The likely beneficiaries of this shift are better represented among US small caps than large.

Geopolitical risks with Russia, China and elsewhere may continue and increase in the coming months and years. It’s possible that globalization as we’ve known it in the 21st century has peaked in the US. If this is the case, US companies may look to invest domestically in areas including manufacturing and supply chains. This means that US smaller companies that fall along these supply chains or in these areas of manufacturing could benefit. This is especially true considering that we still expect capital spending to be strong in the coming years.

Quality: The key consideration in small-cap investing?

Fundamentals remain strong for US small caps. As do relative valuations. In fact, the valuation of small caps relative to large caps remains historically low.

Source: FactSet, Bloomberg, abrdn, March 31, 2022. Note: Excluding negative earnings. For illustrative purposes only. Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

And, as we’ve said before, we believe that there are often small-cap opportunities to be found, regardless of market environment, for investors who focus on quality. There are several important considerations when it comes to evaluating the quality of a company.

One is pricing power. Firms with pricing power are more likely to better handle rising input costs and avoid negative impacts on operating margins. Higher barriers to entry and elevated switching costs are two indicators of pricing power. A third is whether a given small company offers differentiated products and services.

There’s still room for niche companies to do well, even in inflationary environments or volatile markets, if their products and services are specialized enough. Other important elements of quality include balance-sheet strength and cash-flow generation.

Nearly one-third of the companies in the Russell 2000 Index, a proxy for the US small-cap equity market, are non-earners, or lower-quality firms that fail to demonstrate these characteristics. Low-quality companies may not have the financial wherewithal to manage their business in the face of more challenging macroeconomic conditions.

In particular, rising interest rates could threaten unprofitable, high-growth companies whose valuations have been supported by the low interest-rate environment that has persisted for the last decade or so.

Businesses characterized by elements of higher quality are more likely to be able to cope with higher inflation, ongoing supply-chain challenges and rising interest rates, even if they’re small. And within small caps, higher-quality companies are attractively priced compared to lower-quality companies.

Source: abrdn, Jefferies. As of March 31, 2022. Represents the valuation of the top quintile of the Russell 2000 ranked on return on equity (“Q1 ROE’” relative to the bottom quintile of the Russell 2000 ranked on return on equity (“Q5 ROE”).

So, the way we see it, smaller companies that fit the quality bill could have an edge over the balance of 2022 and beyond. While there are small-cap companies that meet these criteria across several sectors, we see great potential within technology and industrials, for example.

...the way we see it, smaller companies that fit the quality bill could have an edge over the balance of 2022 and beyond.

Within tech, many companies have high barriers to entry and sticky customer relationships. Software, in particular, could be attractive since it’s built into customer workflows and therefore is very difficult to replace. To a lesser extent, the same thing applies to semiconductors and related equipment. Semiconductors have been at the fore of the ongoing supply-chain disruptions, and capacity constraints have helped them with pricing power recently.

Certain areas of industrials also have attractive pricing power. These often come with a lag, but, generally, companies with differentiated products can help push higher prices onto consumers. The outlook for niche industrials with these unique products and limited competition could improve further as infrastructure investment increases. As this happens, they’ll be able to price for inflationary impacts.

The current market landscape is complicated. Inflation persists, interest-rates are on the rise and major geopolitical events, like the war in Ukraine, have thrown curveballs at a market that’s just emerging from a global pandemic and the attendant effects. But prudent investors can still find compelling opportunities among high-quality small-cap companies with durable business models and unique growth drivers — inflation or not.

IMPORTANT INFORMATION

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

Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

US-080422-169083-1