Time to look at US small-caps?

In 2022, the S&P 500 slid close to 20% in the wake of the Fed’s decision to rapidly hike interest rates. However, equity markets advanced in 2023, recovering some lost ground as the S&P 500 boasted double-digit returns. As at Dec 29 — the last trading day of 2023 — the S&P 500 had risen 24.73% over the year to 4,769.83.

Morgan Stanley expects US earnings growth to trough in early 2024 and rebound thereafter, with the S&P 500 reaching 4,200 in June and ending the year at 4,500. “In the short term, we expect the earnings recession to continue … We continue to recommend a defensive growth and late-cycle cyclical [stocks through a] barbell strategy and look for a durable earnings recovery to emerge during 2024.”

BofA, meanwhile, is much more bullish. Its head of US equity and quantitative strategy Savita Subramanian thinks the S&P 500 will end the year at 5,000, an all-time high. Subramanian remains bullish on equities not because of expected rate cuts “but because of what the Fed has already done and how corporates have adapted”. “Earnings per share (EPS) can and has accelerated as GDP slows, and reshoring has been identified as a tailwind by companies.”

US equities gained 20.0% in 2023 through late November, with the market focused on a short list of artificial intelligence-led tech names. After a three-quarter profit recession ending in 2Q2023, Citi expects final profits for 2023 to be up 0.9%. “We look for corporate earnings to grow by 5.1% in 2024 and 6.8% in 2025.”

Thanks to the “Magnificent Seven” — Amazon.com, Apple, Google parent Alphabet, Meta Platforms, Microsoft, Nvidia and Tesla — the largest US tech-related shares drove the majority of global equity returns last year.

However, Citi believes this is unlikely to continue into 2024 and 2025. “For 2024, we expect profitable small- and mid-cap growth shares with solid balance sheets will see renewed interest and there are other potential well-valued equity opportunities globally,” says CIO Bailin.

Citi points to a “wide valuation gap” between the market-cap-weighted S&P 500 and small- and mid-cap (SMID) stocks. These stocks, which carry less debt in their capital structures, should benefit from earnings growth and narrowing valuation gaps.