The Magnificent Seven behemoths have been dominating investment markets and have been given added momentum over the last 18 months or so by the growth in AI (artificial intelligence). This was reinforced by the recent earnings season in the US.
While the share price growth of the Magnificent Seven has rewarded investors, we believe it will pay to focus on small caps in the US, as elsewhere in global markets, going forward. US smaller companies have underperformed significantly amid the monetary tightening seen in the last two years. This is to such an extent that they currently offer attractive valuations at significant discounts versus their historical levels.
We have been leaning towards a positive view of US smaller companies for some time. And in our most recent (1st quarter of 2024) tactical asset allocation (TAA) review, we raised our rating from a neutral three to a positive four, based on a scale of one to five, with one being the most bearish and five the most bullish. The arguments in their favour are not different from three months ago but they have become even more compelling.
Against the backdrop of a strong US economy, US smaller companies offer positive fundamentals. Furthermore, it is anticipated that interest rates will be cut by the Federal Reserve this year, which will provide further support. As smaller companies, they present higher risk but they do tend to be quicker out of the blocks in a recovery and we are firm believers in a small cap premium over the longer term.
We also believe that US small caps should continue to benefit from President Biden’s key bills, such as the Inflation Reduction Act and Infrastructure Investment and Jobs Act. It is a point understood by active managers, most of whom tend to be overweight smaller companies.
Outlook for cash cut
In our 1st quarter TAA review, we also reduced our conviction level for cash from a neutral three to one. This was an aggressive cut but we felt it was the right move because inflation appears to have peaked and is falling. The next logical step is for interest rates to fall, and a reduced running yield on cash will make the asset class less attractive.
We had raised the score for cash from two to three in the 2nd quarter of 2023. Cash had become more attractive after the interest rate hikes of the current cycle but the real return that can be achieved on cash is low and capital markets may provide a better alternative for those with a longer time horizon or greater risk budget.
The biggest enemy to savings is inflation. Cash can be a useful safe harbour in the short term, but it represents an active decision to not invest. Over the medium to long term, staying in cash means missing out on the long-term benefits of investing in markets, which includes generating ‘real’ inflation-beating returns. Over the long term, equities have outperformed cash, bonds and inflation.
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