Benefit from a new economic cycle



For the first time in more than a decade, a new business cycle is underway – a cycle of ‘reflation’ characterized by faster economic growth, higher inflation and ongoing monetary and fiscal stimulus, which will benefit to small businesses around the world.

Advisors and investors alike should expect quality assets, which have been underappreciated for some time, to once again become in demand, as the trends that defined the post-global financial crisis (GFC) period give way to new ones. themes. Specifically, the following themes are expected to become features of the investment landscape:

  • In a sustained economic recovery, improved profitability is likely to provide value stocks with the “scarcity” factor that growth stocks previously enjoyed. At the same time, the rise in bond yields will make questionable valuations of growth stocks vulnerable;
  • The greater scale of economic activity, across and within economies, will allow small businesses to benefit – especially those that take advantage of the anticipated strength in consumer and investment spending; and
  • Stronger economic and market performance is expected beyond the United States, particularly in Europe where there is room for a prolonged growth phase. Indeed, official projections predict that European growth will exceed that of the United States over the next five years.


Who would have thought that one or two global crises would actually benefit equity investors? It has been 13 years since the GFC and almost two years since the onset of COVID-19 and, in each case, investors have made solid gains after the initial “shock”.

In the case of COVID-19, global central banks simply dusted off the GFC’s successful playbook: Quantitative easing resumed, bond yields hit new lows, and markets rebounded. Meanwhile, the future was looming, as the adoption of digital technology accelerated. COVID-19 has therefore escalated two of the most pronounced themes that have driven ROIs from the GFC:

  • Falling bond yields and weak growth have reinforced the market bias in favor of growth stocks (those with favorable long-term profit prospects) over value stocks (those with high profitability today); and
  • The technological revolution, in which companies involved in hardware, software, streaming services, social media, and internet shopping – especially dominant American names – have thrived.


However, as the global threat of COVID-19 abates, the economic disruption of 2020 gives way to other powerful forces:

  • A combination of massive stimulus measures, soaring house prices, high precautionary savings rates and pent-up demand has created a powerful cocktail for consumer spending in major economies;
  • Infrastructure spending and bottlenecks in industries from semiconductor to healthcare and transportation are triggering an investment boom. Indeed, Standard and Poor’s estimates that the world’s largest companies will undertake capital expenditures worth US $ 3.7 trillion ($ 5.1 trillion) in 2021, while The Economist says the boom in capital spending “may be just getting started”; and
  • Global growth has become highly synchronized, with authorities adopting a clearly “pro-growth” stance. Moreover, policymakers are likely to err on the side of caution in removing stimulus measures, with the International Monetary Fund (IMF) urging supportive monetary and fiscal policy “to the extent possible” and “until the end. end of the pandemic ”.


The cycle is also motivated by a change in philosophy on the part of policy makers. In the United States, for example, the budget response to COVID-19 stood at 25% of gross domestic product in June 2021 and is expected to increase further with the Infrastructure Investment and Jobs Act, which is considered a “generational investment.” . “for the American economy.

In Europe, the European Central Bank has taken a more inflation-tolerant and growth-friendly stance by announcing a subtle but significant change in its inflation target (from “below, but close to 2%” to “2%” % medium term. ”) and a commitment to achieve the target through an“ always accommodative monetary policy.
These policy changes are likely to occur over the years, providing lasting support to the theme of ‘stronger and wider’ growth and to small businesses in sectors and regions that have fallen behind in recent years (including including quality small businesses in Europe and those focused on consumer demand and business investment).


In unique circumstances, investors cannot assume that the strategies of the past few years will continue to bear fruit. The strategies and positioning of the portfolio must adapt to the new environment and while absolute returns may be a bit more difficult to come by, a quote from billionaire Berkshire Hathaway investor Charlie Munger emphasizes the importance of seeking value. : “Every smart investment is a valuable investment – get more from you pay”.

Today, this value is likely to be found in places that were previously “unloved”. We favor exhibitions for quality small companies in Europe. We also encourage investors to look to companies that can benefit from the release of pent-up consumer demand and increased capital spending.

While these themes are expected to unfold over a long period of time, short-term indications are already favorable. European markets have outperformed the United States in recent months – including small businesses – as there are early signs of a value rotation and relative gains in the industrial and retail sectors. the consumption. However, it is still in its infancy and investors still have time to capitalize.


After underperforming for much of the past decade, “value” certainly describes the small-cap sector, as shown in Chart 1.

The chart shows the very attractive valuations of US and European small and large cap stocks (in a single indicator), with small cap valuations currently trading 28% below the long-term average.


To provide additional context, Chart 2 shows three cycles of performance for US small and large cap stocks over the past 30 years, including the following episodes of small cap outperformance:

  • Until February 1994 (three years, nine months): the 1990-91 recession and the Gulf War saw small businesses enter a cycle of outperformance that began in November 1990 and provided excess returns of 50%;
  • March 1999 to April 2006 (seven years, one month): A protracted recovery, incorporating the 2001 US ‘technological’ recession and subsequent credit-fueled growth, saw small-cap stocks outperform large-caps by 94% ; and
  • April 2008 to March 2014 (five years, 11 months): GFC and the widespread implementation of quantitative easing have seen returns of small companies exceed those of large caps by 28% during this cycle.

The average duration of these four bullish phases is 5.5 years, with small cap stocks outperforming by an average of 57%. Assuming a similar cycle length to the August 2020 low in the small-cap performance ratio, this suggests a recovery that could extend into 2026.


A recession started relatively early in each of the three periods of small-cap outperformance. This has to do with recovering earnings and improving risk appetite – both of which favor the performance of small-cap stocks – which typically follow recession (but can be anticipated by the market before the end of the market. recession).
Using the recessions of 1991, 2001 and 2008 as a guide, the peak performance of small caps was reached, on average, four years after the recession. On this basis, it is not unreasonable to expect the current small-cap cycle to continue until 2024.

In conclusion, the valuation and economic setup is in place for a cycle of outperforming small caps. While investing has always been and always will be inherently uncertain, history suggests that we are only in the early stages of recovery.

Stephen Milch is a consultant economist at Pengana Capital.



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