How Will the Election Affect Small Caps?

Royce Investment Partners: We asked three of our small-cap experts to weigh in on the effects the 2020 elections may have on small-cap prospects.

    Charlie Drelfus

    Charlie DrelfusPortfolio Manager, Managing Director

    Francis Gannon

    Francis GannonCo-Chief Investment Officer, Managing Director

    Steve Lipper

    Steve LipperSenior Investment Strategist, Managing Director & President, RFS

    Portfolio Manager Charlie Dreifus—The economy needs focused stimulus, regardless of which party is in charge.

    To the extent that we get more focused stimulus, it should benefit small caps regardless of the party that provides it. By “focused stimulus,” I mean policies designed and implemented to have multiplier effects on the economy. These initiatives would include expenditures on important areas such as infrastructure, a broadband build out, and targeted tax incentives. The first two of these three expenditures would produce jobs and increase economic activity while also making our economy more productive. For their part, the targeted tax incentives—which should cover tax credits for the purchase of a home or a car—would improve the economy in two of the biggest and highest multiplier impact areas of our economy. 

    How does this filter down to small caps? Because our asset class is much more domestically oriented than large caps, small cap stocks should feel these stimulative effects more quickly and strongly than their large cap siblings.

    The offset, to some degree, would be higher corporate taxes under a democratic win. Again, due to their more domestic focus, corporate tax increases would affect small caps more meaningfully. However, I believe that, even allowing for possibly higher taxes, the net effect of a generous fiscal stimulus package combined with targeted tax incentives would still favor small cap stocks.

    The wild card, as it were, is a vaccine. While a fiscal package would likely cause a sharp risk-on factor rotation into cyclical names, the rotation could be that much more robust once a vaccine or even effective treatment becomes widely available. These characteristics, coupled with strong finances, suggest that these companies can stay the course. When demand improves even slightly and leading to inventories being re-stocked, these companies will enjoy pricing power.

    Co-CIO Francis Gannon—Current economic momentum matters more than political outcomes.

    I continue to believe that, while the outcome of the election is important, its significance pales in comparison to the strength of the current economic recovery, which will have a more dramatic impact on the performance of small caps going forward. It is also worth bearing in mind that the influence any president can have on the economy and the markets hinges on their ability to enact legislation.

    On that score, we will need to wait and see which policies are implemented and whether or not they have their desired effect. The election could well act as a catalyst for near-term rotation into more reflationary assets both domestically and internationally as the global economic recovery broadens out.  To be sure, I expect the dollar to fluctuate around the projected size of a stimulus package. 

    Increased federal spending, coupled with an accommodative Federal Reserve, will continue to support the economy in these uncertain times of the global pandemic. Headline volatility is therefore almost certain to remain elevated. However, as economic activity expands, small caps should outperform their large-cap siblings, and cyclicals should outperform defensive areas of the market—which has been the long-term historical pattern.

    I think this is especially likely going forward in light of what should be a robust global rebound for the economy. Much of this is contingent on the development and distribution of a vaccine, of course, but my overall outlook is positive. I believe that investors can take some comfort in the idea that the cyclical nature of the global economy tends to be a more influential factor in the performance of equities than politics.

    Senior Investment Strategist Steve Lipper—Elections matter less to small-cap performance than industry and company-specific factors.

    Whenever anyone asks me about an election’s potential effects on small-caps, I have three perennial responses—and this year I also have one more that’s relevant to our current circumstances.

    First, while elections can have significant consequences for us as citizens, they generally have far less impact for investors than is widely believed. Small caps have both done well and poorly when either party has occupied the White House. Second, we should all be humble when offering predictions about the effects of any policy or development not simply because unexpected events rear their heads (such as the 2008-09 Financial Crisis and the current pandemic), but also because investors tend to overweight the impact that government actions can have on stocks.

    The most recent example was the rally in small-cap bank and energy shares in the two months following the 2016 election. The consensus was that the incoming Administration would deregulate financial and energy activities, creating a boon for each. However, industry-specific headwinds have made energy and bank stocks among the worst equity investments over the past four years. In my experience, industry supply and demand dynamics play a much bigger role than regulatory changes.

    Third, a sweep is far more consequential than whichever party wins the White House. In today’s highly partisan environment, the likelihood for consequential investment legislation looks low—unless one party gains majorities in both houses of Congress in addition to the White House. And even in that case, the long-term effects are likely to be less meaningful compared to where we are in the economic cycle.

    As for our current situation, the economy is recovering from a deep but short-lived recession—in this case, one caused by a public health crisis. As such, it differs from most previous corrections in which some kind of financial excess has been the culprit, and so we are likely to see a faster recovery.

    Moreover, economic recoveries have historically benefited small-cap stocks, and we expect this one will be no different. If we elect a dividend government, the recovery is likely to proceed at a moderate pace. If one party sweeps, then we may get a more significant fiscal response, driven either by tax cuts or spending increases. Either way, a significant increase in fiscal stimulus would likely improve what we think is already a favorable climate for small-cap stocks.

    DEFINITIONS

    Global Financial Crisis refers to the economic disruption that followed the collapse of prominent investment banks in 2007-8, marked by a general loss of liquidity in the credit markets and declines in stock prices.

    A global pandemic is the worldwide spread of a new disease. The World Health Organization declared COVID-19 to be a pandemic when it became clear that the illness was severe and that it was spreading quickly over a wide area.

    Large cap (sometimes called "big cap") refers to a company with a market capitalization value of more than US$10 billion.

    Small cap refers to stocks with a relatively small market capitalization. Market capitalization is the total dollar market value of all of a company's outstanding shares; it is calculated by multiplying a company's shares outstanding by the current market price of one share.

    The U.S. Federal Reserve, or “Fed,” is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

    WHAT ARE THE RISKS?

    Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

    Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

    U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.