Inflation is challenging small and mid-cap stocks: Strategist

Markets have been undergoing a correction as major market indexes (^DJI, ^IXIC, ^GSPC) struggle and have seen consecutive daily losses as of late. BofA Securities Senior US Equity Strategist and Head of US Small/Mid-Cap Strategy Jill Carey Hall joins Market Domination to discuss the market outlook.

Hall acknowledges that a correction was looming: "It had been a while since markets had seen any significant pullback." She notes that the ongoing earnings season would have investors scrutinizing company outlooks amid higher inflation, geopolitical risks, and uncertainty attributed to expectations around the Federal Reserve's monetary policy.

Throughout 2024 so far, Hall highlights that markets have seen "inflation data that surprised to the upside," which has led to Fed rate cut expectations being pushed out further into the year. She cautions that this could affect the performance of small-cap stocks, boosting refinancing risks in the sector.

When asked about how investors should position themselves in the current market conditions, Hall recommended seeking exposure in sectors such as Energy, Industrials, and Materials, stating "it's an environment where it makes sense to be active rather than passive."

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

This post was written by Angel Smith

Video transcript

- How do you view the market's recent downbeat trend? Is this a correction that was needed in stocks? Or do you think this is more macro, as the path forward for rate cuts remains murky, along with some of those escalating geopolitical risks overseas.

JILL HALL: Thanks for having me. Well, look, I think we hadn't seen a 5% correction or 10% pullback in the market in some time. Usually 5% S&P 500 pullbacks happen about, four times a year, 10% corrections happen about once a year. So it had been a while since the market had seen any significant pullback. I also think, we're in earnings season now, investors are going to be focused on the outlook for guidance which has been weak, usually it is seasonally weak at the start of the year, but we'll see if that improves as more companies report.

Obviously we have geopolitics, and inflation data that's continued to come in hotter than expected, which we do think many, many large cap corporates can still hold up if the Fed doesn't cut as soon as some investors may be expecting. But, but it could prove more challenging for some segments of the market like US small caps, at least for the near term.

- And Joe, you mentioned those hotter than expected inflation prints. We have PCE on Friday. Of course, the Fed's preferred inflation gauge. What do you expect in the air, Joe? How important is that data point for the market?

JILL HALL: Well, I think investors are going to continue to watch the inflation data that feed into what the Fed is looking at. And obviously January, February, and March, we generally saw inflation data that surprised to the upside. So our economists at B of A had pushed out their expectation for the first Fed cut to December of this year, instead of June.

So against that backdrop, we think the Russell 2000 small cap index may be more challenged to outperform until we can get more confidence that inflation is easing. The small cap index does have a lot of refinancing risk. You have more than 40% of the debt for that index is either short term or floating rate.

But, but I still think that given the macro picture, there are a lot of positives for stocks that are more GDP sensitive, more sensitive to the manufacturing recovery or higher commodity prices, that don't have as much leverage or are as exposed to refinancing risk. So I still think there are pockets of small and mid caps that could be poised to do well near term, but overall, that's one reason that the index may be challenged until we get a little bit more confidence that inflation is starting to more sustainably ease.

- And Joe, what are those pockets with small and mid-cap companies, and how would you advise investors to best position themselves there?

JILL HALL: Yeah, I think when you look at it by sector, some of the sectors that are more exposed to the GDP manufacturing recovery to higher commodity prices, but that have less refinancing risk would be energy, industrials, materials, so the commodity complex. And I think it's an environment where it makes sense to be active rather than passive, pick stocks and sectors, given some of these risks to many small and mid cap corporates.

We do still like value over growth, but again, I think large cap value may be a bit more insulated near term if rates stay higher for longer. But the ISM is now back above 50, manufacturing conditions have improved. So that is bullish for a number of small and mid caps that don't have a lot of leverage on their balance sheets.