International | 12:25 PM
The health of the US economy trumps presidential politics, argues Federated Hermes’ Charlotte Daughtrey, with quality smaller cap companies to benefit most.
By Charlotte Daughtrey, Equity Investment Specialist at Federated Hermes
US election years, such as 2024, tend to be good periods for small and mid-cap (SMID) investors as the higher relative domestic exposure of these companies (c.70-80% versus c.50% for the S&P) typically benefits performance.
Presidential candidates across the political spectrum recognise that a strong economy wins votes and domestic smaller companies – the backbone of the US economy benefit from this.
Since the Hoover administration, the S&P500 has delivered an average of 6.2% annualised return in an election year. The Russell2500 doesn’t have data going back to the 1930s, but since its inception in 2003, it has outperformed the S&P500 in every election year.
Notable also to the negative is the 2008 election, held in the midst of a significant economic downturn. While the returns from both indices were very poor, SMID did not meaningfully underperform large cap. While one datapoint doesn’t make a trend, it is something for those waiting on the sidelines (or hiding in safe’ mega-cap tech) to perhaps ponder.
Will 2024 follow this pattern? The Presidential race so far has been fraught, with two failed assassination attempts on Trump and the clumsy withdrawal from the Presidential race of Biden.
Up to that point, most pundits had concluded that a Trump win was all but insured (and the market had responded accordingly) but since the entry of Harris into the race, much has changed.
The betting markets now see the outcome as much more finely balanced with either candidate a possible winner and the result ultimately depending on a small number of swing states and a matter of only a few thousand voters. We shall see.
Given this uncertain backdrop, we believe that the best way to invest is in high quality companies with durable competitive advantage and sustainable growth, which are likely to continue to perform irrespective of who ends up in the White House. This will be our investment team’s fourth election cycle, and a key lesson has been that economics pardon the pun always appears to trump politics.
So, let’s look at the Federal Reserve: we are anticipating -150bps of further cuts over the coming months (in addition to the recent -50bps cut) which should act as a helpful tailwind to the economy and aid in achieving the much desired soft landing (we would take a bumpy landing, which we feel may be more realistic.).
Inflation appears to be moving in the right direction and cracks in the economy (particularly the lower end consumer) seem to be contained at this stage. Employment, although patchy in places, remains robust.
Yet the valuation of SMID cap companies remains low, both relative to large caps and their own history as much bad news has been baked into stock prices. This is likely to change over the coming quarters, in our view, as the broadening out’ trade which we saw in July reasserts itself.
Specifically, we would anticipate ongoing profit taking in the “Magnificent 7” stocks coupled with reinvestment in a broader section of the market. This should reduce the valuation gap (currently 25%+) from historically large levels. A change in earning momentum is likely to be the catalyst for this: the winners of the last few years may not prove to be the biggest winners in the market going forward.
Elections typically generate a lot of noise. That said, it is important not to get distracted and remain focused on company fundamentals. As we stand now, the economic outlook appears acceptable, rates and inflation are heading down and SMID valuations are low.
This gives us confidence that, as in previous election years, the outlook for US SMID companies is promising. Since the team’s inception in 2009 they have delivered an annualised return of 15.2% (net of fees).
A strategy focused on high quality, cash generative businesses bought at reasonable valuations has ensured attractive long-term returns, whichever party held the White House. There doesn’t seem to be any reason to change that expectation now.
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