Opportunities on the Horizon: Investing Through a Slowing Economy

Thematic updates | WEALTH OUTLOOK 2023 | MID-YEAR EDITION | 41 growth shares, led by non-cyclical health care and technology firms. Small-cap value benchmarks are closely tied to performance of regional banks. It is hard to be sure the cascade of small bank failures is behind us, while further consolidation is likely, but broad regional bank shares should recover once economic conditions stabilize. Regional banks play a key role in the US economy, facilitating and underwriting loans to small businesses in local markets where large banks are not players. From a valuation perspective, regional banks have only been cheaper on a price to tangible book basis during the depths of COVID and during the Great Financial Crisis. While it may be premature to add in a tactical window, quality small cap value shares look compelling at current levels with a multi-year time horizon. With capital costs still high, stick to profitable small caps While the value proposition in small-cap shares is apparent, moving down in cap does not come without taking on some additional risk. When the Global Investment Committee moved SMID to overweight in April 2020, economic and pandemic-related conditions were still highly uncertain but policy was unambiguously supportive. Investors unfortunately don’t enjoy those same tailwinds today, with the Federal Reserve still yet to signal a shift towards easing and US fiscal deficits more likely to contract than expand in coming years. The longer interest rates stay high, the greater refinancing risk will be for small, more highly levered companies. Given this uncertainty on the interest rate front, our preferred way to play the SMID space is through an up-in-quality approach. Profitable small firms are more likely to survive a period where capital costs remain elevated than those that rely on access to debt or equity markets to sustain growth. This is a segment of the equity market where active management can add real value by hunting for under-the-radar opportunities while avoiding value traps at risk of stagnation or bankruptcy. What to do with expensive defensives Hiding out in value and defensive sectors was a winning playbook in 2022. Dividend growth shares outperformed the broad market by 12%, while sectors like energy, pharmaceuticals, staples and utilities delivered positive performance as growth shares plunged. This ongoing macro uncertainty has led many investors – including us – to hoard stability in portfolios. FIGURE 1 : Large Cap (Nasdaq) vs Mid Cap Growth Valuations 10 15 20 25 30 35 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22 '23 Forward 12m PE Nasdaq Mid Cap growth Source: Bloomberg as of June 1, 2023. Mid cap growth proxied using S&P 400 Growth Index. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. For illustrative purposes only. Past performance is no guarantee of future results. Real results may vary.