Lower interest rates conducive for bigger risk appetite, small caps

As interest rates continue to fall, small caps are poised to reap from the current macroeconomic backdrop and investors increasing their appetite for more risk, a fund manager says.

Janus Henderson portfolio manager Nick Sheridan predicts the tide is turning for small cap stocks, which have been overlooked for some time.

Back when interest rates lifted out of negative territory and ratcheted up, investors became fearful.

"When people get fearful, they run away from anything that's got to do risk. Investors also believe that, operationally, small caps are more volatile than large caps," Sheridan recently told Financial Standard.

This is typically because in a large cap portfolio there are five or six businesses that will average out the volatility of others. In small caps, only one or two businesses will do this.

Sheriden saw investors turn away from small caps as interest rates went up for reasons that hikes would be negative for GDP growth. They also anticipated the US heading into a recession.

"They ran away from small cap stocks, and they went into large caps stocks. Large caps are typically less risky than small caps from an operational perspective. And one of the big beneficiaries of all of that, in my opinion, was the Magnificent Seven," he said.

The correlation between large and small caps, which has been falling in recent years, is something he urges investors to consider.

"Basically, what that means is if large cap were to fall substantially, it is not necessarily the case that small caps would fall as much," he said.

"And if you look at the top end of the market over in the US, you can see that the business models are changing. Having largely been intangible asset-driven companies, the likes of Microsoft, Meta, Alphabet are all investing in data centres. Data centres are hard tangible assets, and the return profile you make on hard tangible assets is not normally as good as you make on intangibles."

What is certain, he noted, is that global small caps are materially underpriced relative to their large-cap brethren. Looking at the top seven companies in the US, the "discrepancy is even wider."

Most central banks around the world are now more dovish and find themselves in a global easing cycle.

The European Central Bank (ECB) cut its interest rate to 2% this month, for example, while the Bank of England cut to 4.25% in May.

"Interest rates reducing are good for small caps, because small companies tend to borrow shorter term rather than longer term," he explained, of about three to four years.

"If you think that globalisation is being pushed back, then the area that benefits the most from that is probably small caps, certainly not large caps. Then with interest rates, that benefits small caps some more. If there's a degree of inflation in the system that benefits equities in general."

Furthermore, the characteristics of some small caps are generally more value orientated.

"What that means is that they will generally be able to increase their prices at a time when inflation is going forward, rather than independent of that," Sheridan noted.

And as for the impact of US President Donald Trump's tariff war? Sheridan said geopolitical uncertainty and the risk of tariffs have seen businesses actively seek to shorten supply chains by moving production and processes closer to home.

"This could favour small caps, which have much more domestic exposure than their larger peers, particularly in Japan and the US, where domestic revenues are 75% and 78% respectively. Small caps also have more exposure to sectors like industrials and materials, areas we expect to benefit from the onshoring and near-shoring trend," he said.