US Mid-cap Equities – Economic Exceptionalism at a Reasonable Price
US exceptionalism remains intact, benefitting exposures more directly linked to economic growth. We believe that within US equities, mid caps — which are domestic, cyclical, and offer a relatively undemanding valuation — are particularly well positioned over the medium term.
Macro Backdrop: The US and the Rest
The economic leadership of the United States contrasts with a slowdown observed in the rest of the developed world. Importantly, this strength has been and continues to be underappreciated; in the beginning of 2023, economists pencilled in just 0.3% growth against a 2.5% realized and in 2024, initial consensus estimate was 1.2%. But by 28 March, expectations for growth this year were already upgraded to 2.2%. The two pillars of US strength are fiscal spending and strong consumption despite tighter financing conditions.
Meanwhile, European economies are either in or on the edge of recession, with much softer growth realized in 2023 and estimated growth pencilled in going forward. In addition, US productivity rose by 2.6% in Q4 from a year earlier, while the Eurozone saw a decline of 1.2%.
Not a Niche Exposure
In this environment, we believe that US mid caps are in the sweet spot, allowing them both to embrace the benefits of US exceptionalism and mitigate key challenges related to higher valuations. While market participants often only consider overweighing small or large caps, we believe that mid caps should not be neglected as they can combine the merits of both worlds in a single exposure. In fact, the S&P MidCap 400® Index is not a niche segment, with a total market capitalization comparable to some of the main European large-cap indices. We therefore believe that the S&P MidCap 400® Index may serve as a core long-term part of a portfolio rather than just a tactical overweight.
Long- and Short-term Performance
While investors may be focussed on the S&P 500® Index’s strong performance since the start of 2000, US mid caps have actually outperformed large caps by a wide margin. More recently, from the end of 2022 through November 2023, US mid caps lagged as larger stocks were perceived to be better prepared for the higher rate environment. However, since November, the combination of stronger-than-expected growth, moderating inflation, and an increasingly dovish Federal Reserve allowed US mid caps to take off, returning 28.9% as of 27 March.
The question after such a strong rally up from October lows is whether there is any upside potential left. In our view, the investment case still has very solid foundations built on three pillars:
- Domestic profile
- Cyclical sector composition; and
- Valuation levels of the S&P MidCap 400® Index
Mid Caps Domestic Profile
Companies within the S&P MidCap 400® Index generate 77% of their revenues within the United States while the corresponding number for the S&P 500 Index is 59%.1 The domestic profile of mid-cap companies is an obvious tailwind, given the robustness of the US economy and relatively soft growth elsewhere in the developed world.
Sector Composition of Mid Caps
Mid-cap companies heavily overweight cyclical sectors. The strength of the US economy and upgrades to economic growth projections should benefit more cyclical exposures. Industrials is the largest component, accounting for 22% of the mid-cap index. Industrial companies are likely to continue benefitting from long-term fiscal initiatives (such as the Infrastructure Investment and Jobs Act, CHIPS and Science Act, and the Inflation Reduction Act) and more broadly reshoring efforts. The second-largest sector is Consumer Discretionary, which includes more traditional retailers, hotels, or restaurant operators. The sector remains resilient thanks to robust consumer spending which, alongside fiscal policy, is the most important pillar of US exceptionalism. The mid-cap index is underweight towards defensive sectors like health care and also towards technology.
Valuation Levels for the S&P MidCap 400® Index
The S&P MidCap 400® Index remains relatively affordable with a forward P/E at 16.5x, compared to the S&P 500 Index at 21.2x. This is even more pronounced when taking into account historical patterns. Valuation remains a key investor concern when considering US equities, so the broad market-cap-weighted S&P MidCap 400® Index offers a solution to that challenge. Importantly, lower multiples do not come at the expense of earnings quality — during the Q4 results, companies within the S&P MidCap 400® Index beat expectations by 8%, while companies in the S&P 500, which also had a strong set of results, delivered an aggregate beat on earnings of 7%.2