By Curt Organt, portfolio manager of the T. Rowe Price US Smaller Companies Equity strategy
Amid multi‑decade high inflation, 18 months of interest rate rises, and ever‑present fears of recession, the resilience of the US economy has generally been underappreciated by many investors.
The US economy expanded by an annualised 4.9% in the third quarter of last year, the fastest pace in nearly two years. Meanwhile, inflation fell to 3.2% in October, marking a spectacular decline from the 40‑year high of 9.1% recorded in June 2022.
One of the primary forces behind the US economy’s resilience has been the continuing strength of consumer spending. A strong jobs market with a high level of employment means US wages are rising, while excess savings are also at historically high levels.
Importantly, US consumers are also less immediately exposed to the steep rise in interest rates than many other countries. About 90% of US household mortgages are fixed rate, with a large percentage secured at long‑term interest rates well below the high rates available today. In short, individual balance sheets are in better shape than prior to the pandemic, giving consumers the confidence to keep spending.
However, we are also seeing a shift in underlying spending trends, away from goods and into services. With smaller company earnings much more geared to the services economy, this shift should help to fuel favourable relative earnings growth.
Similarly, US companies, large and small alike, have also moved quickly to downsize or refinance debt since the pandemic, resulting in generally healthier balance sheets, more cash, and less exposure to interest rate fluctuations.
Diversity in a concentrated market
A great deal has been written about the highly concentrated top end of the US equity market. The S&P 500 Index has become increasingly focused in a very small group of mega‑cap companies, commonly known as the ‘Magnificent Seven’.
Smaller companies offer a much more diversified exposure to the vitality of the US economy and a different risk profile to large‑cap investing. The domestic bias of smaller companies, and more balanced exposure at the sector level, means they are often better positioned to benefit from changing trends in the US economy.
For example, the trend toward supply chain localisation or ‘onshoring’/’reshoring’ of US industry is gathering pace. We have already seen a sharp rise in manufacturing and construction activity directly attributable to company onshoring/reshoring and this seismic shift is still only in the relatively early stages. Smaller companies, which tend to be more geared to the domestic economy, stand to benefit from this concerted shift away from globalisation in favour of more locally driven supply chains.
Smaller company pricing power
Smaller companies are often assumed to be price takers, with limited ability to exert pricing power. In fact, many smaller businesses operate in underserved or niche industries – such as fintech, computer gaming, e‑commerce, and green energy – and so command more pricing power than their size might suggest.
When these businesses begin to experience inflationary pressure, be it through supply chain bottlenecks, wage increases, or due to rising input costs, they are able to pass on these higher costs to customers, thereby helping to protect profit margins.
Even if a smaller company cannot control the price of an end product, it is not necessarily powerless to influence its own revenues/profits. For example, many smaller companies can be critical components within more complicated processes or supply chains. As has been painfully clear in recent years, high demand and limited supply of any component along the supply chain gives pricing power to the component producer.
A premium for improving productivity
While a more positive economic outlook this year is important for smaller companies at a broad level, improving productivity is likely to be a key driver of topline performance at a company level. With this in mind, there are many good opportunities to be found, often in less studied sectors, which are having a meaningful impact in terms of enabling improved productivity.
Some of the most important aspects of our lives, in key areas like financial services, healthcare, and agriculture, for example, have not really been reimagined in the way that sectors like technology or communications have. We are seeing significant investment in these areas, and innovative smaller companies are frequently at the forefront of this advancement.
Finally, in terms of relative valuations versus larger peers, smaller companies have fallen to historically low levels, despite earnings remaining relatively resilient, and history tells us that small‑caps outperformed strongly in an improving economic environment.
