Our Investment Q&A this week is with Bob Kaynor, manager of the Schroder US Mid Cap fund, who digs a little deeper into the US economy. We touch on the ‘Magnificent Seven’ and how they shed light on a wider issue: can the level of concentration in the S&P 500 continue? Or is the AI bubble set to bust? We navigate through the unique challenges posed by student debt, higher interest rates, the US consumer, the employment cycle and the potential impact of upcoming global elections on the market.
Why you should listen to the interview: It’s a fascinating listen to an active manager’s view of the US economy and how so many factors impact his investment universe and portfolio. Bob is clear about what is driving the current performance of the S&P500 but is not too starry-eyed to think it will go on for ever, and offers interesting insights into how and why he believes the small / mid-cap space is due to rally.
Quotes of interest:
The S&P 493
“The dynamic in the US equity market is that we really have two markets: we have a market of seven stocks, and everything else. Earnings growth this year, as well as price performance, has been dominated by just seven companies – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. But, excluding those companies, the S&P – I’ll say 493 – is basically flat on the year. So, all of the return that you’re seeing is dominated in a handful of stocks.
“The market, frankly, is as concentrated as it’s ever been, both from a weightings perspective as well as an earnings growth contribution perspective. One way to gauge this is if you look at the difference in return between the S&P 500 – which is market cap weighted – and the S&P Equal Weight Index, you will see that the return has never been this wide unless you go back to the late nineties, so it’s a very similar dynamic that we saw in the late nineties, and I would say generally, it’s not necessarily a healthy market where you have very narrow leadership.
“Do I think it is set to continue? The answer is, we are at historical extremes, so there’s no reason that can’t continue. But I would also say that it’s probably about as far as it seems to go. I mean, we are so dominated by just a small handful of stocks and you’re starting to see the market broaden out recently where participation’s expanding, beyond just those Magnificent Seven, and I think that’s a very healthy dynamic, not just for mid-cap companies, but really for any index that is not so market cap dominated.”
Key drivers of the small & mid-cap sector
“I think that the valuations are at extremes. They are priced so you are getting paid to take risk in the small and mid-cap market. If you just go to your classic, business school kind of equity risk premium, there is a large equity risk premium that exists in the small and mid-cap space and a negative equity risk premium that exists in the large cap space. So, that tells me that it doesn’t take much to be right and to get rewarded.
“Valuations are extreme, fundamentals are improving, and I think importantly, it is the fundamental improvement that’s going to drive that change. And the fundamental improvement in the small and mid-cap space in the US is going to be driven by fiscal stimulus.
“We’ve had a large amount of stimulus get approved, whether it’s the Inflation Reduction Act, the CHIPS and Science Act, the infrastructure bill, all of that is incentivising domestic spend and domestic manufacturing – and the small and mid-cap companies are poised to be the main beneficiary of that. So, that’s where I see the catalyst for the change occurring.
“And I would tell you through our work, we are seeing that money through those fiscal stimulus programmes just start to get released and just start to flow downstream. And that’s where we can make the case for improving fundamentals, which is what matters.”
Small and mid cap stocks – ready to break out?
“It is always hard to pinpoint the exact time when the tide is going to turn. From our perspective, we build mosaics; everybody in this industry works with less than perfect information, so you try to build mosaics and make the case.
“But I will tell you that this space, small and mid-cap stocks, feel like a ball being held underwater. You started to see that outperformance last year. In fact, I think what’s lost on a lot of investors, is if you looked at the end of February 2023 and you look back over the trailing 12 months, small and mid-cap stocks were outperforming large cap by 500 basis points. That was into an environment of the Federal Reserve raising rates, of downward earnings revisions, and the market pricing in at the time everybody expected an imminent recession. And yet small and mid-cap stocks were outperforming because we had a similar dynamic to what we’re experiencing today. And I’ve always argued that it’s not the cycle you’re in that matters, it’s what the starting point is. And the starting point was extreme.
“Not to go too far into it, but what unraveled that kind of momentum for the asset class, frankly, was what happened with the regional banks in March, with the small and mid-cap banks. What happened in the banking crisis in March 2023, was a small and mid-cap problem, which created significant downward earnings provisions in the space. And I think that that is what prompted the trade out of small cap into large cap that we saw in March of this year, further exacerbated by what we saw in May with NVIDIA and their tremendous earnings report.
“So, understanding kind of what changed the momentum is important, and I think that the pendulum is poised to swing back in the favour of the small mid-cap space as you start to see improving relative earnings. And that’s what’s going to matter.”
“The US consumer is in a very tenuous situation”
“When I think of student debt, I view it as a bifurcated consumer in the US, and when I think of student debt, it’s really not about the low end consumer. The US individual that has student debt is of a higher income cohort. They tend to be homeowners, they tend to have good income. I don’t think student debt is going to be the problem for the US consumer.
“Frankly, I am more concerned about what happens to the employment cycle. We’ve started to see deterioration in some credit metrics that impact the low-end consumer, but we haven’t yet seen unemployment turn the wrong direction. I get concerned with the US consumer when we see the services industry slow down and that’s where many of the low income consumers get their jobs.
“I think the US consumer is in a very tenuous situation. We talk a lot about pent-up savings. I don’t spend a lot of time looking at the savings rate data but I think if you check the history, you’d see that it is the most revised set of government data there is, and there was a big revision again that was made to pent-up savings last month. So, from my perspective, I am worried about the consumer. I take some comfort in the fact that a lot of our enthusiasm for the fundamental improvement is being driven by fiscal stimulus that’s already in law, where the money is already allocated and is finally starting to flow downstream.
“But I don’t think the US consumer is what is going to pull us into a recession, unless we see a quick and sudden deterioration in the employment picture.”
Conclusion: When Bob said, “Investing in US equities, we don’t ‘go big or go home’, but instead ‘go mid and do not overbid,” he set a clear framework for his stock picking style. His feeling that valuations in his sector are “unsustainably cheap” combined with an improving fundamental backdrop should give investors cause to reconsider the potential in the US small/mid-cap sector — and the future of the US consumer.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views are the fund manager’s own and do not constitute financial advice.
Main image: dyana-wing-so-g4mUJ0pZODg-unsplash
