Krishna expects small caps to continue to underperform their larger peers amid slower domestic economic growth next year, which “could take the wind out of the sails for top-line growth” at small firms. While Barclays is not forecasting a recession next year, analysts expect “risk aversion to firmly be in place,” which will hurt small-cap stocks.
Despite perceptions that domestic firms are more insulated from the trade dispute with China, small companies actually have higher exports and imports relative to their sales, as well as lower margins and less pricing power to pass along higher tariffs to customers, Krishna points out. Barclays estimates tariffs to cut small-cap Ebitda growth by around 2.5 percent over the next year.
BofAML, Equity and Quantitative Strategist Savita Subramanian
Bank of America continues to prefer large caps over small caps in 2019. Small, domestically focused firms have posted “weaker trends than large caps the past few earnings seasons, management is guiding more below than above consensus on earnings, and small caps have seen more earnings estimate cuts than raises by analysts.”
Leverage near record levels is also a “key risk.” More than half of small firms’ debt has floating interest rates, leaving them more exposed to rising rates and widening credit spreads.
Analysts forecast volatility, measured by the VIX, to double over the next three years, which doesn’t bode well for small caps. Investors should stick to large caps. “What works when volatility rises? Quality of earnings,” analysts led by Subramanian wrote in a Nov. 20 note.
Jefferies, Equity Strategist Steven DeSanctis
DeSanctis says small- and mid-cap investors should get used to bigger swings after this year’s roller coaster ride. “We want to be domestic,” as global growth is not showing signs of improving, DeSanctis wrote in a note earlier this week.
Concerns about an inverted yield curve are “overblown,” and “if it’s one hike, three hikes, doesn’t matter. Fed raises equals OK performance” for small caps in 2019. The strategist also forecasts that 12 percent earnings growth for small firms is achievable, despite reduced estimates due to a stronger dollar. Merger momentum should remain strong as valuations have come down and larger companies are looking to grow.
To weather volatility, investors should stick to quality stocks, which are “very cheap,” DeSanctis points out. Jefferies’s new sector allocation leans toward growth over value, and the firm is now more bullish on beaten-down tech stocks, while bearish on communication services. Financials were cut to market weight from overweight as earnings growth estimates for 2019 need to come down.