Small caps could be winners in an anticipated second-half rebound
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Be prepared for more market volatility through to the end of the June quarter, says Principal Global Investors.
But the investment firm’s chief global economist, Robert F. Baur, said small cap stocks could be among the sectors that benefit as part of a second-half rebound.
Investors are nervously awaiting the first round of numbers for the June reporting season, when companies will be forced to provide additional clarity on their near-term earnings forecasts.
And by their nature, equity markets are forward-looking in the process of ascribing valuations to shares.
So it makes for an interesting setup; how do you value a short-term economic contraction if you take the view that activity (and earnings) will return to normal over the following 12 months?
Adding complexity is the risk increase in geopolitical tensions, and a lack of knowledge of how the external health crisis will play out; will there be an accelerated vaccine or health treatment, or will major economies be forced to adjust to a second wave of viral outbreaks?
In a recent research report, Principal’s chief global economist said the April rally indicates investors were “looking past the crisis and focused on earnings gains from reopening” of major economies.
But he warned investors to brace for more volatility through to the end of the June quarter.
Focusing on the US market, Baur said the “backstop” provided by unprecedented policy stimulus should prevent the S&P500 from retesting its March lows at the 2,200 level.
However, “earnings pessimism should return at some point and we can envision a relapse to 2,600 or below”. If such a move eventuates, it would represent a fall of 11.2 per cent from the S&P500’s closing level on Friday.
In that environment, Baur expects the big tech to outperform “as markets consolidate and thrash about before the next move higher”.
But on a six-to-nine month basis, investors should try and position their portfolios to benefit from the tailwinds when growth accelerates.
That cohort includes small-cap stocks, along with “energy, materials, consumer discretionary and financials”, Baur said.
Like most investors though, Principal takes the view that adopting a long-term approach isn’t applicable in the current environment.
“All these suggestions are tactical, short-term in nature. This is not a time to make long-term investment decisions,” Baur said.
“It’s possible that equity returns, even over several years, may not be very rewarding”.
Baur highlighted that recessions usually have a “job” to do in resetting the economy and changing unproductive practices.
But because this recession is so unique — driven by an unexpected external catalyst unrelated to economic or financial markets — economies could return to growth while previous issues remain unaddressed.
Those issues include economy-wide company profits, which have been “flat for five years” in the US, Baur said, along with anaemic growth in economic productivity per capita.
In view of that, Baur highlighted the possibility of a second downturn which could play out over the next couple of years.
“We’re still fully invested for now. Be positive for this year but stay vigilant for a major change in the investment framework,” Baur said.