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Fed rate hike strengthens US SMID opportunities

The data simply proved too strong: as expected, the Federal Reserve has increased the base US interest rate to 75bps amid strengthening economic indicators. These include:

  • Growth: GDP increased at an annualised rate of 3.2% in Q3, and was followed by a recent surge in services activity last month
  • Unemployment: the jobless rate fell to 4.6% in November, its lowest level in more than nine years
  • Inflation: the Consumer Price Index rose 1.5% in the year to September, suggesting that inflationary pressures are rising

The central bank’s willingness to hike was evident in the Federal Open Market Committee’s minutes from its November meeting, which stated: “Members generally agreed that the case for an increase in the policy rate had continued to strengthen”.

Our view is that US interest rates will likely continue to chart an upward trajectory as the extraordinary monetary policies of the post-financial crisis era give way to pro-growth fiscal stimulus and deregulation. We believe that this environment favours small- and mid-cap (SMID) stocks.

Implications for US SMID stocks
A direct effect of higher short-term rates is a further increase in long-term bond yields, which had risen in expectation of yesterday's decision, and will help improve the profitability of regional banks.

More broadly, US small caps typically outperform large caps during interest-rate tightening cycles as they are more heavily exposed to domestic growth. From 1963 to 2012, small companies generated an average total return of 13% in periods when interest rates rose, compared to the 8.1% return from large companies1 .

As rates tighten, the stimulus measures announced by US President-elect Donald Trump should benefit US SMID companies, particularly those in the following sectors:

  • Materials: the $1tn pledged to infrastructure investment will benefit aggregates suppliers and other companies linked to road construction
  • Energy: less domestic regulation, and OPEC’s commitment to cut production, should benefit shale oil and gas producers
  • Industrials: a cyclical upswing is typical of a pro-growth environment
  • Banks: higher short-term rates, less regulation and a steepening yield curve will benefit regional lenders

US SMID stocks are currently valued in line with their long-term average, with the Russell 2500 trading on an 18.5x 12-month estimated forward price-to-earnings multiple. The S&P 500’s multiple of 16.9x means that SMID companies are trading in the range of their average premium of 2x over large caps.

We believe that the combination of higher US rates and fiscal stimulus is creating a new investment environment where convincing opportunities exist down the market-cap spectrum.

  1. 1WSJ Research as at 2014

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