Traditionally, a thriving stock market is good news for the electorate.
Collective savings support young local companies that in turn can enhance the prospects for the local economy. Local collective capital, invested locally, can be used by the local companies to create additional skilled employment that in turn can improve productivity.
Importantly, long-term improvements in productivity justify wage increases ahead of inflation, on a sustainable basis.
Furthermore, as local companies pay most of their tax locally, a local stock exchange typically boosts the exchequer’s tax take as well. National stock exchanges that are full of young businesses can deliver value for those with saved capital as well as those without any saved capital, as the invested funds can lead to improvements such as sustainable wage growth, extra funding for schools and hospitals, the need for more skilled employment, boosting productivity.
Of course, it’s the mainstream established corporates that usually get most of the media coverage. This emphasis is all wrong, in my view. Large, established listed companies may raise capital to accelerate growth and scale up dividends, but being international, the prime beneficiaries are remote.
Few large-cap placings lead to meaningful additional employment or productivity improvement locally. At least that represents what used to happen, but with globalisation everything changed.
Reducing trade barriers boosted global growth, and many multinationals were the best placed to take advantage. In addition, over time, sophisticated multinationals found they could accelerate growth further via tax havens.
The extra-large-cap growth has gradually skewed capital allocations into passive funds. Meanwhile, many younger quoted businesses have lost out due to a higher cost of capital.
And with globalisation persisting, institutional investors have progressively exported the vast majority of our collective capital to the US. In addition, some large caps have moved their primary listings to the US in the hope of getting a better stock market valuation. All the while, many younger companies have missed out.
Generally, globalisation greatly favours ‘bigness’. And given that, generally, large caps have generated excellent returns for decades, many equity income investors have tended to limit their investment universe to the equity income majors, because they tended to have abundant market liquidity.
But the current portfolio skew ignores the electorate’s views. To keep globalisation going, central banks have frequently had to resort to quantitative easing.
Distorting market prices, in time, has led to misallocated capital. And as capital has been concentrated into the US mega caps, this has meant that many small caps, with their extra productivity, have lost out. Global productivity has flatlined, and hence many voters have not had a decent pay rise in years.
The net effect is that the electorate has started voting against globalisation. First, it was Brexit. Then European far right parties won ever-larger support. But importantly, Trump has been elected US president. Twice. If international stock markets didn’t get the message the first time, the electorate has now handed him a clean sweep. This time he can impose protectionism by executive order without the usual checks and balances.
If globalisation generally favoured bigness, the implication is that we should expect nationalism and protectionism to favour smallness. Imposing arbitrary trade barriers is like throwing sand into an engine. The extra friction slows everything down.
All this poses an enormous problem for market participants. During globalisation, they have typically maximised returns via large-cap transactional strategies and their plentiful market liquidity. But with nationalism and protectionism, some of these strategies now carry giant correlation risks.
US mega caps are now so large that individually they carry outsized stock-specific risks. And with AI boosting mega-cap returns, collectively they carry outsized industry correlation risks as well. Just like the dotcom boom, when it ends, we expect the sell-off is likely to be largely indiscriminate.
An urgent need to diversify
Institutional investors now have an urgent need to diversify risk within their equity allocations. But where do they go?
A knee-jerk answer is to scale up equity income weightings. Their returns are somewhat uncorrelated with technology majors. But during the Covid pandemic, many mainstream equity income strategies had more risks than many anticipated, becoming overly reliant on long-distance suppliers during globalisation.
During Covid, the consequent dividend cuts were large and wide-ranging. Although governments may have fostered a recovery subsequently, much of it has relied on governments running much larger budget deficits.
Hence, come the next economic downturn, there are good reasons to be very careful about an over-reliance on large-cap equity income stocks alone. Government budget deficits are already maxed out. And global supply chains now have to address trade tariffs as well as an over reliance on long distance suppliers.
As all this bumps up inflation, interest rates rise will detract from mainstream service and technology earnings.
Overall, we are fearful that any large-cap dividend cuts may turn out to be a lot more permanent this time.
Younger companies differ. Being relatively small, when they succeed, they typically succeed in local terms first. And being young, they are often early into new immature industry sectors. They are not a silver bullet of course. But our view is that younger equity income stocks that succeed have the potential to generate disproportionately strong returns.
Specifically, those young, listed equity income stocks with surplus cash flow have the opportunity to accelerate earnings growth by moving into the markets vacated by the weak. But the best upside opportunities are likely to come from acquiring over-leveraged but otherwise cash-generative companies from the receiver.
If these come at a time when most corporates are short of surplus cash flow, the acquisition costs are sometimes trivial.
HSBC acquired Silicon Valley Bank UK for just £1 for example. Whilst the upside on the deal may have amounted to millions, HSBC was already a large market capitalisation. In the case of young, quoted small caps however, these value uplifts can sometimes amount to a transformational uplift versus their initial market capitalisation.
The bottom line is that following globalisation, many small-cap equity income stocks are currently starting from sub-normal valuations. Better still, as capital allocations start to move down the market capitalisation bands, their effect is amplified.
During globalisation, illiquid small caps meant that most investors could not get out. During nationalism however, it will start to mean market participants will not be able to get enough capital in.
To conclude, I believe that we could be starting a new small-cap equity income super cycle. Given investor concentration in mega caps, in my view, the new small-cap equity income super cycle could be set to last for decades. Good for market participants, but also good for the whole electorate.
Gervais Williams is head of equities at Premier Miton
