Expect Outperformance by Canadian Small Caps in the Years Ahead

Even at the beginning of the year, there were signs of a rough road ahead.

Just as every corner of the globe rang in the first quarter and started to emerge from the COVID-19 crisis, Russia’s invasion of Ukraine set the world back, postponing a return to normal life. Coupled with substantial spikes in inflation worldwide, soaring oil prices, worsening global supply chains, and a significant tightening cycle in the planning stages, there were enough key headwinds to slam global equities, credit, and many other risk assets.

In the face of a broad selloff across the market cap spectrum in the second quarter of 2022, small-cap and large-cap stock investors could not completely escape the deep and sustained paper losses so prevalent during the period. Quite simply, there were almost no places to hide for anyone, other than cash and low-quality energy stocks.

The result was after delivering double-digit returns for three straight years, the TSX Small Cap Index is having what anyone would consider a tough year, posting a third quarter year-to-date (YTD) return of negative 16.3 per cent due to a rapidly deteriorating macro environment. Had it not been for the positive contribution of the energy sector, the only GICS (Global Industry Classification Standard) sector in positive territory, the index’s performance would have been far worse.

Widespread and Broad

To give you a sense of how widespread and broad this bear market has been, more than 50 per cent of the stocks in the communications, information technology, consumer discretionary, and industrial sectors within the TSX Small Cap Index are down at least 20 per cent YTD. In a stark contrast to this broad selloff across sectors, the energy sector has dramatically outperformed all the other sectors year-to-date due to soaring oil and gas prices.

The drivers of this steep pullback were certainly plentiful, starting with relentless and sustained high inflation data that remains problematic and well above acceptable levels, plateauing at 40-year highs.

With such strong price appreciation across the board, the Bank of Canada and other major central banks have had no choice but to maintain a hawkish stance to fight and tame inflation. Hence, investors have had to digest round after round of significant benchmark rate increases, with clear signals that there are more rate hikes on the way.

With raised expectations for higher inflation and interest rates, the spectre of a more significant recession started to loom larger in the third quarter, dampening market sentiment further and hitting risk assets hard. In the process, investors have become resigned to the fact that the Bank of Canada and other central banks have abandoned hopes for a ‘soft landing’ and will continue to aggressively raise interest rates to fight inflation ‒ even if it takes a heavy toll on the demand for goods and services, sooner rather than later.

Small Caps Lead the Way Out

In this heavy risk-off, unsupportive environment, Canadian small-cap stocks ended the third quarter trailing Canadian large caps by close to 500 basis points (bps) YTD ‒ with high volatility, widening credit spreads, and an inverted yield curve acting as predictable headwinds.

Given a backdrop of high inflation, rising interest rates, and weaker demand, investors should, under any realistic scenario, brace for a probable recession in Canada and elsewhere in the coming months. They also should not be surprised to see some steady downward revisions to corporate profits for this year and 2023 ‒ for Canadian companies of all sizes.

The one saving grace is the weak Canadian dollar, which will likely be a tailwind for both small and large caps. Since no major components of the economy seem to be seriously impaired or structurally damaged and the labour market has remained stubbornly healthy, we should see a relatively modest or ‘normal’ recession by historical standards.

Economic Downturn

After what’s been a meaningful bear market in our small-cap universe, most of the impending or forthcoming economic downturn is already priced into Canadian small-cap stocks, since it has been more pronounced than the average decline for this asset class in the first half of a recession. P/E ratios hit the low of 2008.

Furthermore, Canadian small caps are trading at the biggest discount to Canadian large caps for the first time in the past 22 years. They will undoubtedly lead the way, coming out of this downturn with stronger earnings growth and much more attractive valuation levels.

Small-cap companies remain, however, more volatile than large caps and require a thorough analysis before investing. It is important to choose high-quality, reasonably valued, and profitable companies to increase your chance of success. By high quality, we include a solid track record in different macro environments, no balance sheet risk, and high-growth potential.

Gabriel Bouchard-Phillips is a Senior Portfolio Manager at Van Berkom Global Asset Management.