The overall outlook for the global economy is uncertain, with multiple signs of losing steam and fading momentum in some of the most resilient economic pillars. However, despite the macroeconomic challenges, there is optimism toward small-cap stocks.
The U.S. economy is showing signs of losing momentum, with challenges such as high inflation, interest rates, a weak housing market, tight capital markets and a slowing job market.
Despite these macroeconomic clouds, the outlook for small-cap stocks remains optimistic. Small-cap stocks in the U.S. have underperformed large-cap stocks in recent quarters, but this has made small caps even cheaper and more attractive from a valuation standpoint, with the potential for positive earnings surprises and outperformance. The downward revision to earnings forecasts for 2023 may set the stage for potential outperformance as companies beat these reset expectations.
Additionally, historically, small-cap stocks have performed well in an environment of high but falling inflation, which is currently the case. Furthermore, after a bear market, small-cap stocks tend to rebound, providing an opportunity for investors to outperform large-cap stocks and other asset classes early in the economic cycle. Despite potential market volatility, investors with a long-term horizon may achieve solid returns in the small-cap category.
While market volatility may persist due to the uncertain macroeconomic backdrop, a multi-year investment horizon is expected to yield solid long-term returns in the small-cap category. In the current challenging macro environment, it is important to remain positioned in reasonably valued, high-quality small-cap stocks. Companies with attractive valuations, strong profitability, solid balance sheets and that are expected to benefit from secular growth tailwinds should generate meaningful alpha over the benchmark.
Canadian small-cap stocks are currently trading at a substantial discount relative to large-cap stocks, marking the largest discount in 22 years. This presents an intriguing opportunity for investors seeking differentiated returns.
The underperformance of Canadian small caps in recent quarters has resulted in more attractive valuations, with many companies trading below their historical averages in terms of price-to-earnings (P/E) ratios and price-to-sales (P/S) ratios. This suggests that there may be significant upside potential for Canadian small-cap stocks as they rebound from the recent market weakness.
In addition to attractive valuations, Canadian small caps also benefit from the domestic economic recovery. The Canadian economy has been showing signs of resilience, with improving GDP growth, declining unemployment rates, and a rebound in consumer spending. As the economy continues to recover, small-cap companies are expected to benefit from increased business activity and improved corporate earnings.
Furthermore, the Canadian small-cap market offers diversification opportunities. While large-cap stocks in Canada are heavily concentrated in a few sectors, such as financials and resources, the small-cap segment offers exposure to a broader range of sectors and industries, including technology, healthcare, and consumer discretionary, among others. This diversification can help investors reduce risk and capture potential upside from different sectors of the economy.
A visit to Milan revealed that Italian companies are increasingly embracing digitalization, supported by government incentives and regulatory reforms. Many companies are investing in technology such as artificial intelligence, big data and cloud computing to enhance their competitiveness and productivity. These efforts are aimed at improving operational efficiencies, streamlining supply chains and expanding market reach.
The overall tone of the European economy is also improving, which bodes well for small caps. The region is benefiting from increasing clarity on the path of inflation and interest rates, which has helped alleviate uncertainty and boost investor confidence. Europe is also expected to benefit from the renormalization of supply chains and inventory positions, as global trade recovers from the disruptions caused by the pandemic. This is expected to have a positive impact on small-cap companies operating in the region, particularly in the manufacturing and logistics sectors.
Moreover, Europe offers attractive small-cap stock opportunities for sustainable investing. The region has been at the forefront of the global push towards sustainability, with many companies focusing on environmental, social, and governance (ESG) factors in their business strategies. This presents an opportunity for small-cap investors to align their investment portfolios with their sustainability goals and potentially benefit from companies that are leaders in ESG practices.
A trip to Tokyo revealed a positive outlook for the region, driven by the relaxation of local Covid rules and China’s reopening. Many Asian countries, including Japan, South Korea and Taiwan, have been successful in controlling the spread of the virus and are gradually lifting restrictions, leading to a recovery in domestic demand. China, which is a major trading partner for many Asian countries, has also been reopening its economy, providing a boost to regional trade and economic activity.
However, Asia also faces long-term challenges related to an aging population. Many countries in the region are grappling with declining birth rates and an aging workforce, which could impact economic growth and consumer spending in the long run. To address this issue, companies in Asia are increasingly adopting technology and outsourcing labor domestically and internationally. This presents opportunities for companies involved in IT outsourcing, M&A advisory, labour outsourcing and senior care, for example, to provide solutions to this structural challenge.
In addition, Asia remains a vibrant hub for innovation and technology. Many Asian countries, such as China, South Korea and Japan, are known for their cutting-edge technology companies, particularly in areas such as artificial intelligence, robotics and electric vehicles. These companies are at the forefront of technological advancements and are well-positioned to benefit from the growing demand for innovative solutions in various industries, both domestically and globally.
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