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The investors might see another all-time high for small-cap stocks in 2024
Market Outlook

The investors might see another all-time high for small-cap stocks in 2024

We are exploring how the market will behave in the coming months, with the change of the year.
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11 DEC, 2023

By Federated Hermes

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Stephen Auth, CFA, Chief Investment Officer for Equities at Federated Hermes

The hope that springs eternal within the breast of every investor is for a slow, steady rise in the market to ever higher levels, as positive fundamentals gradually work out in the form of solid earnings growth and steady valuations. 

Unfortunately, in today’s world of 24-hour news cycles, geopolitics, asynchronous micro and macroeconomic cycles, global trade wars and heavy involvement in the private economy by monetary, regulatory and fiscal authorities, markets have a way of zigzagging up and down in ways that sometimes obscure the underlying trend. And while 2024 is sure to have plenty of noise for the market to chew on daily, by this time next year at least, it may prove to be the most “normal” year for equities since the pre-Covid era. Our outlook, though among the high Wall Street forecasts Street at 5,000 on the S&P 500, is only 9% above present levels, and if achieved, would be a rarity. Over the last 20 years, a single-digit positive return has only been recorded four times. 

And after the wild ride of the last four years, 9% would be welcome in our books. More importantly for stock pickers such as our gang at Federated Hermes, the real action in the market is likely to happen beneath the surface, driven by smaller and mid-sized stocks that really haven’t participated until recently in the big rally this year. This theme of a market that is more of a grind than a hockey stick led by these unappreciated stocks, and not the “Magnificent Seven,” is one we’ve been talking about on these pages since the summer.

Geir Lode, Head of Global Equities at Federated Hermes Limited

Small cap stocks measured by the Russell 2000 index have dropped by almost a third since its peak in November 2001. This is a decline typically associated with a recession. With a recovery time on average of a year, investors could see another all-time high for small cap stocks in 2024. 2023’s positive market returns can be explained entirely by US mega cap growth stocks.

With fewer signs of a recession on the horizon, economic indicators have turned bullish for the equity markets. Inflation is trending down and labour market figures are finally softening, indicating that interest rate levels have peaked. Market sentiment indicators have turned bullish with the VIX sitting close to an all-time low, and treasuries yields paring back from recent highs. Historically, Small cap stocks have benefited the most in similar macro-economic environments..

Whilst rally inducing festive cheer is not in short supply, there is a risk that the inflation and interest rates stay higher for longer. In general, small cap stocks have higher debt levels and shorter maturities of their debt. Higher interest rates leave an expensive re-financing burden that could punish highly levered firms and the small cap stock recovery. Small caps benefit from a calmer environment, but we are paying close attention to debt burdens and refinancing timelines. 

Mohammed Elmi Lead Portfolio Manager – Emerging Markets Debt at Federated Hermes

While some of the high frequency economic data has turned slightly more positive (perhaps indicating a cyclical bounce), the medium-to-long term issues remain. In 2024, policymakers will have to address the real estate market and its associated debt in the form of developers’ borrowing and mortgages for growth to meaningfully recover. Directly and indirectly contributing to around 25% of GDP, a solution to the real estate recession would be welcome and could prove to be significant

The 2024 US Presidential Election also has the capacity to affect EM risk in a profound manner, as any change in bilateral relations between the US and individual EM countries or blocs can impact spreads. One of the most significant geopolitical risks in this context, is an escalation in trade tensions with China. A Biden win could see a continued softening in relations, as witnessed in their most recent talks in California. A Trump win could see the return of a transactional foreign policy where sanctions are used to achieve key policy objectives, but is also realistic to anticipate that any change in the White House could once again spark an escalation. 

In our opinion the Chinese fixed income space in 2024 remains challenged and unattractive on a valuations basis. Therefore, the importance of looking beyond China cannot be understated, as recently highlighted by the outperformance in countries such as Mexico, Brazil, Peru, and Turkey.

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