The current U.S. inflationary environment has weighed on the economic outlook. This bout of inflation, which began amid pandemic-induced supply-chain bottlenecks, has persisted even as Covid pressures have begun to show signs of slowing. And it’s only gotten worse as the war in Ukraine has escalated.
However, we believe that U.S. investors need not panic. In spite of the complicated market backdrop, we see opportunities in small-cap equities for those who are able to tune out the noise and focus on quality.
Small Caps Face Different Risks Than Large During Times Of Inflation
Compared to large caps, how should we expect small-cap equities to perform in periods of higher inflation?
On one hand, small-cap equities present greater risks than large caps during times of inflation. This is because smaller companies may have a harder time than their larger peers absorbing higher expenses. And smaller companies are often more labor intensive than large ones, so if the higher costs of labor continue to play a role in this current period of higher inflation, small-cap profits could be at risk. These risks are especially applicable to smaller companies with less-diverse supply chains or those that are more exposed to input or commodities costs.
However, we believe that when it comes to small caps and inflation, there are plenty of reasons not to throw the proverbial baby out with the bathwater. In fact, there are historical examples of small caps performing relatively well in times of heightened inflation.
Keeping Current Inflation In Context Compared To The 1970s…
The current inflationary environment, which has seen gas prices (among others) jump, may call to mind the last period of significant inflation in American history—the 1970s. During this time, despite the risks associated with small caps in periods of high inflation, they outperformed their larger peers (Source: Jefferies Equity Research, JEF SMID-Cap Themes, March 17, 2022).
High inflation in the 1970s came about because in the years prior, policy had been too loose for too long. And it was made worse when the economy was hit with an energy shock in the form of an embargo from the Organization of Arab Petroleum Exporting Countries (OAPEC). In response, the U.S. Federal Reserve (Fed) had to carry out significant policy tightening (namely, raising interest rates significantly) in order to bring inflation back down.
Similarly, the current inflationary period also comes after a period of very supportive monetary policy. And, once again, we are in the midst of a period of rising inflation that’s gotten worse from an energy shock—this time in the form of the Russian invasion of Ukraine and the subsequent economic weaponry (i.e., sanctions) that Western nations have fired off in response.
But there are important differences between the inflation of the 1970s and the period we’re experiencing now:
1. Central bank inflation targeting—Today, the Fed employs inflation targeting, a policy that involves adjusting monetary policy in order to create price stability, or control inflation levels. Inflation targeting is meant to help central banks respond effectively to shocks to the domestic economy. The Fed developed today’s inflation-targeting framework with the lessons of the 1960s-70s in mind.
2. Long-term inflation expectations are anchored—In the 1970s, people lost faith in the Fed’s ability to bring inflation down, but today, most Americans don’t believe that high inflation will last long term. Survey data suggests that average inflation over the next five years is expected to be 3%—well below the spikes we’ve seen this year (Source: Michigan consumer confidence survey, March 2022). These longer-term expectations make it easier for the Fed to react accordingly now.
3. The Fed has a plan and is putting it to work—The Fed has responded to the current inflation situation, introducing the first of several planned interest-rate hikes in mid-March. And its plan is slow and steady, which gives the Fed a good chance to monitor the impact of past interest-rate hikes closely.
4. We live in a global economy today—Right now, we’re still feeling the burn of global supply-chain disruptions that are the direct result of the Covid-19 pandemic. But these supply-chain issues will eventually work themselves out over time.