So far, large caps’ battle cry remains unchallenged, as small caps’ slings and stones appear to be no match for the sword, spear and javelin.
In our Equity Outlook, we reiterated a preference for U.S. large caps over U.S. small caps. Fortunately, the former’s continued outperformance year-to-date bolsters our conservative view on the size cycle.
Keen observers are aware that small-cap growth stocks have had a great year, and are up over 20% in 2017. Still, large-cap growth stocks have been the biggest winners, as they’re up more than 30% this year.1
In fairness, we acknowledged some of the good things that small caps have going for them, including easy credit conditions in the form of loose bank lending standards for small firms. However, the credit environment is showing signs of becoming less hospitable, which further strengthens our case for large caps.
Historically, credit spreads (or borrowing costs for risky businesses above the risk-free rate) have been highly correlated to the performance of large caps relative to small caps. Specifically, the outperformance of high-yield corporate bonds relative to Treasury bonds has usually been a good barometer of investor risk tolerance and appetite for smaller, younger companies.
However, a big divergence has opened up between credit market trends and equity market-cap patterns. On one hand, high-yield corporate bond spreads have tightened back toward their lows of the current credit cycle, helped by the rebound in oil prices and recovery in the high-yield energy sector since 2016. On the other hand, large caps have maintained their pole position relative to small caps year-to-date.
Which is right – the credit market or the equity market? Where else can we look for clues?
If past is prologue, the wedge between credit market trends and equity market-cap patterns in 2014 cautions that the current divergence may resolve to the upside, in favor of large caps.
Elsewhere, the Federal Reserve’s Senior Loan Officer Opinion Survey indicates that credit conditions are easy for small firms seeking commercial and industrial (C&I) loans. 9% of domestic banks loosened lending standards in the fourth quarter of 2017. That’s good news for the small-cap arena, where banks are a more important source of financing (as opposed to larger companies, which have relatively easier capital market access). After all, credit is the lifeline to smaller firms, and crucial for keeping their growth “promise” to investors.
The credit supply backdrop in and of itself wouldn’t be a concern if credit demand were similarly ample, but it isn’t. Indeed, 3% of banks reported weaker demand for C&I loans to small firms, suggesting a gap between the supply of and demand for credit not seen since late 2006. In other words, the demand for credit doesn’t support high-yield corporate bond prices at these levels, with negative implications for small caps.
To be clear, we aren’t calling for an immediate and violent widening of credit spreads. On the contrary, this world of still historically low interest rates and investors’ global hunt for income suggest that high-yield corporate bond prices can remain buoyant. Our message is simply that high-yield credit’s risk/return profile has changed, and the bulk of continued rapid price appreciation is probably behind the asset class.
When we change our view on the size cycle, it will be because of a careful and thorough assessment of an array of factors, such as performance regimes, valuations, fiscal and monetary policy, economic growth, geographic revenue exposure, earnings growth, fund flows, currencies and technical price momentum. While David ultimately beats Goliath, the balance of evidence remains in favor of large caps for now.
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- ^Source: Bloomberg, as of 12/18/17.
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