Why small caps could rebound in 2024

Market Recap

• Equity markets held firm this week amid a wide range of market-moving events.

• The Fed Open Market Committee (FOMC) left rates unchanged, as expected, but quashed some expectations of very near-term rate cuts; another flare-up of regional bank concerns reverberated through some pockets of the market; U.S. economic data were rock solid; and, for good measure, some large tech names like Meta posted strong earnings and announced some cash will be returned to shareholders—even tech investors love themselves some dividends.

• All in, the S&P 500 rose 1.4%, with consumer stocks leading the way, while the TSX dipped 0.2% on weakness in telecom and energy.

The Fed

Last week, as expected, the U.S. Federal Reserve (Fed) held interest rates steady. It was comments from Fed Chairman Jerome Powell, however, that generated headlines, as he poured cold water on markets’ hopes for imminent rate cuts while also seemingly closing the door on further hikes. This is precisely what we expected to happen. Previously in this space, I’d mentioned the possibility that Powell would be more clear-cut about being done with rate hikes. This was the first time he’d made such a definitive statement, and while the Fed does remain data-dependent, it represents an interim step before an eventual pivot to easing. Powell also mentioned that they may not have the necessary inflation information to consider cutting rates in March, which aligns with our expectations even as markets continue to price in the possibility of a Q1 cut. The reality is that U.S. economic indicators remain relatively solid, meaning that there hasn’t been enough deterioration for the Fed to consider hitting the panic button just yet.

Bottom Line: This is the “higher for longer” that we’ve been anticipating for months.

Small Caps

Small cap equities are often viewed as a good barometer of regional economic health, and our expectation for 2024 is that they’re likely to rebound when interest rates come down later in the year. Smaller companies generally have a harder time accessing capital than their large-cap counterparts, meaning that they typically have to pay more for capital—and when rates go up, they have to pay even more still. As such, the likely lowering of rates later this year should be even more beneficial to small caps than to larger companies. The fact that these smaller companies have withstood a higher-for-longer rate regime also tells us that their capital structures are relatively strong and stable, which bodes well going forward. That said, it is important to pay attention to the health of the consumer. Large-cap companies are generally the ones with loyal consumer followings. As the consumer weakens and spending decreases, it’s the nice-to-have items—not the day-to-day essentials—that are more likely to go unbought, and that spending shift may hit small caps the most.

Bottom Line: With a more favourable interest rate environment likely on the horizon, small cap equities are poised for a comeback globally.

Banks

The commercial real estate market has been on analysts’ radar for a while now, especially after the collapse of Silicon Valley Bank (SVB) last year. Could it trigger another regional banking crisis? Our expectation is that it will be a negative for the banking industry in 2024, though perhaps not the disaster some are expecting. Going forward, it’s likely that interest rates will decline, which is a positive. But that doesn’t necessarily mean that the real estate market, and commercial real estate in particular, will completely bounce back, especially with the consumer gradually weakening. Another consideration is work-from-home. We’re unlikely to return to the pre-COVID norm, but we are seeing enough people preferring to work at the office that commercial real estate could rebound slightly. Overall, we expect Financials to do well this year, but not across the board—quality matters in this space, and we prefer banks with strong balance sheets and secure dividends, which generally means the larger banks. Speaking of dividends: New York Community Bancorp recently cut its dividend (and also reported some poor results) and was punished with a 38% plunge in share price, dragging the KBW Regional Banking Index to its largest single-day loss since the SVB crisis¹. Needless to say, bank investors love dividends, and while we think this is an anomaly, it does highlight the risk in some regional banks.

Bottom Line: Commercial real estate may pick up slightly, which would help the regional banks, but within Financials, we still prefer quality.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Cracking the Fed’s Code.

BMO GAM’s 2024 Market Outlook

In this one-hour video, I’m joined by six portfolio managers—specializing in Bonds, Dividends, Healthcare, Real Estate, Financials, and Technology—to share what could be in store for markets in the year ahead, including potential risks and opportunities.