Portfolio Construction Insights

An Extended Path to Recovery and the Case for Small-Caps

U.S. small-caps could benefit portfolios as the economy gradually recovers.

Key Insights
  • It’s been a bumpy road to recovery as economic reopenings likely contributed to an increase in coronavirus infections, which led to renewed public health restrictions in many areas.
  • Capital markets responded favorably to fiscal and monetary stimuli, but a still-challenging economic backdrop suggests that investors should look for sustained incremental improvements in key data.
  • Several key metrics indicate that now may be a good time to add U.S. small-caps to investor portfolios or consider expanding existing positions.

Reopenings, Infections, and Rollbacks Mark a Bumpy Road to Recovery

In the second half of 2020, coronavirus infection rates in several areas of the U.S. appear to be rising again following initial steps toward economic reopenings. The recent infection spikes have forced some jurisdictions to renew business closures and other aggressive public health measures to stem the virus’s spread. As we’ve noted in previous Insights, the inherent conflict between economic considerations and public health concerns is playing a significant role in the public policy debate. It will undoubtedly continue to impact the road to economic recovery and, perhaps more importantly, the pace of that recovery.

Meanwhile, investor sentiment continues to seesaw between two camps depending on the news cycle. When investors see reports about rising infection rates or new treatment challenges, the market tilts toward companies that stand to benefit from continued economic and public health restrictions, including areas such as cloud computing, digital, online shopping, and work-from-home solutions. When there are reports about promising vaccines or optimism about more effective treatment options, investors lean toward companies that benefit from economic reopening, including travel-related stocks, leisure, and entertainment. All of this results in a turbulent market environment marked by wide performance swings.

Our base case is that the second quarter of 2020 likely marked the bottom of the market cycle. Investors are likely to see sharp drops in corporate earnings and murky management outlooks as the second-quarter earnings season progresses. Current estimates for the S&P 500 Index suggest that earnings impact could be long as well as sharp, with the index not expected to reach levels seen in the fourth quarter of 2019 until the third quarter of 2021.

Opening Quote In our view, the market has transitioned from an initial recovery phase fueled by monetary and fiscal stimuli into a consolidation phase in which the economy grinds ahead on an extended path to recovery. Closing Quote

Looking Ahead

In our view, the market has transitioned from an initial recovery phase fueled by monetary and fiscal stimuli into a consolidation phase in which the economy grinds ahead on an extended path to recovery. Investors should evaluate the durability of the consolidation phase by looking for sustained incremental improvements in economic and market data. On the economic front, for example, investors could look for several weeks of falling initial jobless claims or rising PMI figures, while tightening credit spreads could signal improvement on the market side. In simple terms, if the numbers are trending positive across several data sets and multiple time frames, the recovery is likely becoming more sustainable.

U.S. Small-Caps: Is Now a Good Time to Add or Increase Exposure?

In short, the answer may be yes for manyinvestors. Based on the daily interactions between our Portfolio Construction Specialists and financial professionals, it appears that many investors are pivoting their portfolios back toward what has worked well since the 2008-09 Global Financial Crisis: U.S. large-cap growth stocks. However, we caution against giving up on diversification, and we suggest a few reasons why now may be a good time to add or increase portfolio exposure to U.S. small-caps.
 

  • Small-caps outperformed large-caps over longer time periods. A $1 investment in U.S. small-caps made in January 1926 would be worth $31,258 at the end of June 2020. This is more than 3.5 times the $8,859 generated by the same $1 investment made in U.S. large-caps over the same time period.1
  • Small-caps outperformed large-caps over shorter time periods, as well. For those who believe small-cap outperformance is a thing of the past, Figure 1 shows that U.S. small-caps outpaced U.S. large-caps over the 20-year period ended June 30, 2020.
U.S. Small-Caps Outperformed U.S. Large-Caps

(Fig. 1) Russell 2000 vs. Russell 1000, 20 Years Ended 06/30/20

U.S. Small-Caps Outperformed U.S. Large-Caps

Past performance is not a reliable indicator of future performance.
Sources: Russell, T. Rowe Price calculations using data from FactSet Research Systems Inc. All rights reserved.

Relative Valuations Favor Small-Caps Over Large-Caps

(Fig. 2) Key Valuation Metrics, 20 Years Ended 06/30/20

Relative Valuations Favor Small-Caps Over Large-Caps

Sources: Russell, T. Rowe Price calculations using data from FactSet Research Systems Inc. All rights reserved.

 

  • Key valuation measures support small-caps over large-caps. Many financial professionals want valuation support before allocating to or overweighting small-caps to fully capture the small-cap premium. As shown in Figure 2, relative valuations favored small-caps over large-caps at the start of the 20 years ended June 30, 2020, and small-caps outperformed over the period. Currently, price-to-earnings (P/E) ratios still favor large-caps, but price-to-cash flow and enterprise vaue-to-earnings before interest, taxes, depreciation, and amortization. (EV/EBITDA) offer relative valuation support for small-caps.
  • Small-caps tended to outperform large-caps early in recoveries. Using historical data from the last four significant market downturns and recoveries since 1980, Figure 3 shows that small-caps outperformed large-caps in the first one-third of all four previous recovery cycles—and the outperformance was substantial in three of these periods.

Investor Themes and Investment Ideas

In the first half of the year, our discussions with financial professionals can be divided into three phases. In the pre-crisis stage, de-risking and diversification were the main topics as we moved into the later stages of the economic cycle. As the economy and markets felt the full impact of the coronavirus crisis, we cautioned financial professionals to resist panic and encouraged them to maintain a strategic investment approach. And finally, as we attempt to manage portfolios with an eye on a potentially long and turbulent road to recovery, we suggest risk-aware and balanced approaches.

U.S. Small-Caps Outpaced Large-Caps Early in Prior Recoveries

(Fig. 3) Russell 2000 vs Russell 1000, Through the First 1/3 of Previous Recoveries

U.S. Small-Caps Outpaced Large-Caps Early in Prior Recoveries

Past performance is not a reliable indicator of future performance.

Sources: Russell, Morningstar.

Let’s take a look at how these approaches might play out against the backdrop of the four primary investment themes from T. Rowe Price’s Midyear Market Outlook.

1. The Road to Recovery

Capital markets recently have reestablished a preference for U.S. large-cap growth stocks. If the recovery is robust, however, we could see a sustained rotation into underperforming areas such as value, international, and credit-sensitive fixed income sectors.
 

  • Risk Aware
    Consider a barbell approach within fixed income by increasing exposure to high yield, floating rate, and emerging markets bonds while reducing credit risk in shortterm bond allocations to partially offset the additional risk. Among stocks, higher-quality companies with healthy balance sheets and the ability to consistently grow dividends could help mitigate volatility from choppy equity markets.
  • Balanced
    To offset portfolio overweights to growth equities, reduce or eliminate major underweights elsewhere by adding exposure to international, small-cap, and value stocks. Investors could also take advantage of potential bumps in the road to recovery through actively managed global strategies with broad opportunity sets in both equity and fixed income assets.
2. Disruption Accelerated

Stay-at-home and quarantine orders implemented during the coronavirus crisis accelerated several secular trends already rewarding companies that have embraced the digital world, including online retailers, social media, office mobility, and others.
 

  • Risk Aware
    Investors should carefully assess their portfolios’ existing growth and technology exposure as they consider increasing these positions for the recovery. For example, look for active managers focused on companies likely to emerge in stronger competitive positions on other side of the recovery.
  • Balanced
    Investors could consider high-quality core fixed income assets to help offset the risk from overweights to growth stocks in a broader portfolio. To gain exposure to potentially disruptive Chinese technology, consider adding Asia-focused strategies, especially if portfolios are underweight international equities.
Opening Quote Geopolitical turbulence, social justice challenges, a polarized U.S. election cycle, and elevated policy risks create an atmosphere in which today’s top stories can drive short-term market volatility. Closing Quote
3. A Focus on Credit Quality

Fixed income markets have responded favorably to massive monetary and fiscal stimuli designed to address the coronavirus crisis, but bankruptcies and credit issues are expected to rise all the same. This puts a spotlight on the importance of in-depth credit research and active management.
 

  • Risk Aware
    Prudent fixed income plus sector allocations could include high yield, floating rate, and emerging markets given a backdrop of low interest rates and elevated credit spreads. We’ve also seen portfolios use short-term bond strategies with significant high yield exposure. We believe dedicated high yield, floating rate, or emerging markets sleeves offer a better risk/reward profile.
  • Balanced
    Embrace the trend toward flexible, solution-focused investment strategies and let the managers take advantage of credit research resources to identify the best opportunities.
4. Policy, Politics, and Populism

Geopolitical turbulence, social justice challenges, a polarized U.S. election cycle, and elevated policy risks create an atmosphere in which today’s top stories can drive short-term market volatility.
 

  • Risk Aware
    Investors could consider assets that historically have tended to mitigate portfolio volatility, including dividend growth stocks.
  • Balanced
    Look at actively managed global strategies with broad opportunity sets in both equity and fixed income to take advantage of opportunities in markets around the world as they arise. It could also be beneficial to close or narrow significant portfolio underweights to international, smallcap, and value stocks.

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We work with financial professionals to find practical solutions for critical investment and practice challenges. Used independently or in combination, each component of our integrated suite of Portfolio Construction Solutions provides access to T. Rowe Price’s world-class multi-asset expertise and global investment resources to address your portfolio construction needs.

 

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An Extended Path to Recovery and the Case for Small-Caps

It’s been a bumpy road to recovery, but key metrics indicate that now may be a good time to add U.S. small-caps to investor portfolios

1 Small-caps = IA SBBI Small Stock Total Return USD; large caps = IA SBBI Large Stock Total Return USD. Source: Morningstar, analysis by T. Rowe Price.

Additional Disclosures

©2020 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2020. FTSE Russell is a trading name of certain of the LSE Group companies. “Russell®” is a trademark of the relevant LSE Group companies and is used by any other LSE Group company under license. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication. The LSE Group is not responsible for the formatting or configuration of this material or for any inaccuracy in T. Rowe Price Associates’ presentation thereof.

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This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

Information and opinions, including forecasts and forward-looking statements, presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass.

The views contained herein are those of authors as of August 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

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Past performance is not a reliable indicator of future performance. Small companies tend to be riskier than large companies. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

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