A positive start to 2023 for US stocks was disrupted in early March when vulnerabilities in certain US banks, exposed by rising interest rates, triggered a liquidity crisis and deposit outflows. Nonetheless, Manulife Investment Management is optimistic about the potential of US small-cap stocks due to their enticing valuations and their role as emerging catalysts in selected sectors.

To begin with, the asset manager highlights the performance of small-cap stocks so far this year. “While the banking system has since stabilised, the failures and a tightening in credit conditions had a disproportionately negative impact on small-cap stocks broadly…As of September 1, small caps continued to trail their larger peers on a year-to-date basis,” writes Bill J. Talbot, Senior Portfolio Manager, Head of U.S. Small-Cap Equities at Manulife IM. 

However, Talbot informs that gains in US small-cap stocks in 2023 were more evenly distributed across various stocks and sectors as compared to their large-cap counterparts. According to him, this explains why small caps currently offer broader sector diversity compared to large caps. 

Furthermore, despite the current disparity in short-term performance, the asset manager highlights several factors that support investing in US small-cap stocks in the long run. These include their historically attractive valuations, the potential for outperformance during post-recession recoveries, and the fact that they are an under-owned asset class, offering opportunities for active investors.

“While we maintain a positive long-term outlook for small caps, several near-term headwinds pose risks that complicate the outlook through the rest of this year and perhaps beyond,” said Talbot. These risks include uncertainties related to inflation, the pace of interest rate increases, and the possibility of liquidity problems in the banking sector affecting smaller companies.

“Despite these current risks, we see an abundance of many high-quality smaller companies with strong fundamentals and resilient balance sheets to help navigate an environment in which credit has recently become more expensive,” said the asset manager. 

The bottom-up opportunities and the historically low valuations will likely remain in the small caps sector, says Manulife. The asset manager predicts, “We see a fertile current environment for active fundamental investing emphasising a core small-cap approach, with blended exposure across the growth and value equity style spectrum.”

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