US Small Cap Value Weighted – Three Dimensions of Market Rotation
The market rally has been concentrated within large caps, high growth, and tech-related stocks thus far. But investors may want to consider US equity exposures that would allow them to participate in an increasingly likely broadening of the rally as the soft landing unfolds.
The potential rotation may take various forms: 1) size rotation, 2) value rotation, or 3) cyclical sector rotation. The MSCI USA Small Cap Value Weighted Index is a unique strategy with built-in features allowing investors to benefit from any of the three types of rotation.
Soft Landing Odds Increase Again
Recent developments in the US economy create an appealing entry point for small-cap equities. A softer but still exceptional US economy benefits riskier assets, particularly those that are more domestic, as local consumption underpinned by an extremely resilient labour market remains robust. In the short term, inflation dynamics will determine performance as the timing of monetary easing remains uncertain. While the battle against inflation is far from over, April’s CPI at 3.4% YoY (0.3% MoM) and wage growth at +0.2% MoM provided much needed relief. In our view, recent data prints increase the probability of a soft landing and may be a base for a sustained broadening of the market rally.
Extreme Valuation Gap
The concentration of the market rally in 2023 and part of 2024 has led to extreme valuation gaps between growth and value, large and small caps, and the magnificent 7 versus other sectors. The difference in price-to-earnings (P/E) multiples between the S&P 500 and MSCI US Small Cap Value Weighted indices widened to levels that are difficult to justify, as the strength of the US economy lowers the chances of a hard landing scenario. Moreover, the MSCI US Small Cap Value Weighted Index trades at a 23% lower P/E level compared to the market-cap-weighted MSCI US Small Cap Index, a difference significantly below the median level of -16%.
Cyclical Sector Rotation Tool
The MSCI USA Small Cap Value Weighted Index has a heavy cyclical bias.
- Financials represents 25% of the index, and banks account for half of that. It is a significant overweight relative not only to the S&P 500 but also the market-cap-weighted MSCI USA Small Cap Index. While idiosyncratic issues related to loan books or bond portfolios should not be ruled out, the financial sector in the US remains healthy as it is supported by a robust consumer, higher rates, and central institutions that step up when necessary — the latest example being the crisis in 2023 when the US government guaranteed deposits of troubled banks, limiting broader outflows from smaller institutions.
- Industrials (16% of the index) is a sector supported by long-term initiatives such as the Infrastructure Investment and Jobs Act, CHIPS and Science Act, and the Inflation Reduction Act. Broad reshoring efforts are likely to intensify as geopolitical tensions increase.
- Consumer Discretionary (16%) benefits from the remarkable resilience of domestic consumption.
- Information Technology (7%) MSCI USA Small Cap Value Weighted Index underweights defensive sectors but the most important underweight is Information Technology which accounts for just 7% of the index (versus 29% for the S&P 500 Index and 12% for the MSCI USA Small Cap Index).
This composition makes the value-weighted index a tool crafted to position for a sector rotation.