Special Global Small Cap Equity Strategy

Bryant VanCronkhite: The winds of change are upon us and investors need to take note. I am Bryant VanCronkhite, senior portfolio manager for the Special Global Equity team at Allspring Global Investments, and this is our Q2 2024 recap. Over the next several minutes, I will walk through the key macro events that impacted the quarter performance of equity markets across market caps, styles, and factors. I'll then dive deeper into sector specific drivers and, finally, what investors should be watching for and thinking about for the second half of the year. Now, the Federal Reserve (Fed) and the consumer have dominated the headlines for the last several quarters, but we are approaching key pivot points as we enter the second half of the year. The first quarter’s strong equity market returns were led by a free-spending consumer who drove a resilient economy. But during Q2 and early into Q3, we observed increasing signs that spending is slowing and the economy could begin to follow it lower. Retail companies highlighted that consumers are reducing overall spend, delaying large purchases, and shifting from branded products to generic products. Consumer fatigue appears to be setting in and could remove one more leg of our economic stool. Fortunately, capital spending from the lagged impact of past fiscal stimulus, such as the IIJA and IRA bills that were passed during COVID, are still working their way through the economy. Companies are reporting Q2 earnings over the next several weeks and along with it, they'll be updating expectations for the second half of the year. The market will move based on the reported results, but more importantly, we need to listen for clues on forward expectations related to the consumer and capital spending. Inflation, the Federal Reserve, and the path of interest rates have become household topics over the past few years and were once again front and center in the second quarter. Expectations for interest rate cuts are volatile and they ebb and flow with every inflation data point. Exiting Q1 and to start Q2, inflation surprised to the upside and reduced expectations for interest rate cuts. Now, as we exit Q2, inflation has returned to its moderating path but continues to be well above the Fed's 2% target. Now, however, the June CPI print released on July 11 is showing continued signs of slowing. Investors are currently pricing in a little over 75% chance for a cut in in September. That will be highly dependent on inflation continuing to slow and employment metrics showing a balance between supply and demand. Now, for me, I'm much more focused on employment than inflation because one of the keys to confidence in sustained lower inflation is the availability of qualified workers. However, one of the clearest signs of a slowing economy is whether companies have confidence to maintain their workforce. Or, conversely, are they laying off employees? If unemployment metrics rise before the Fed cuts rates, it is more likely that any Fed interest rate cut will be viewed negatively by equity markets as it will be deemed the Fed waited way too long for the cut. To put this into perspective, the S&P 500 has fallen following 7 of the last 8 times the Fed made their first interest rate cut of a cycle. The average job over the last eight Fed cuts was 23.3% and it took the market an average of 213 days from the time of the first Fed interest rate cut to find its bottom. Clearly, the Fed has had a tendency to act too late and this is the central macro debate for this cycle. Will inflation fall and employment balance out, giving the Fed the chance to act proactively before the economy slows? How did macro forces impact equity market performance during the second quarter of 2024? Well, generally speaking, growth beat value and large cap beat small cap. This is a very common performance pattern when investors are cautious on the broad economy. Again, a slowing consumer and sticky inflation is forcing the Fed to hesitate, making investors worried about economic growth going forward. So, investors are pushing capital to the largest companies with the most visible growth. Style factor performance during the quarter was consistent with this general theme of predictability. Momentum was the strongest performing factor, indicating investors have a preference for what has been outperforming recently. A heavy component of this is the mega-cap technology trend, fueled by the ongoing AI investment theme. In addition, the factor of profitability was another strong performing style factor during the quarter. Now, conversely, beta and value-based factors were amongst the worst performers. Investors tend to seek value factors when the economy is broadening and strengthening, two things that were clearly not happening in the second quarter. I should note that style factor performance has been volatile over the past 18 months with swings often hinging on sentiment around the timing of the Federal Reserve's next move. Let's dive next into sector performance. We're going to use the Russell 1000 Index when talking about large caps, the Russell Midcap Index for mid-cap stocks, and the Russell 2000 Index for small caps. When referring to value or growth in our discussion, our comments will be based on the value or growth index for the Russell 1000, the Russell Midcap, and the Russell 2000 Indices. Starting perhaps with the most talked about sector, information technology, those companies deemed the early winners of the artificial intelligence arms race performed very well, making the IT sector the best performing in the Russell 1000 Growth Index. However, as you move down in market cap, the technology sector’s relative performance dropped. Within the growth indices, the mid-cap tech marginally outperformed while small cap tech lagged behind the returns of the respective overall index. On the value side, technology outperformed across all market caps, but it wasn't the top performer at any market cap level. What that tells us about information technology is that stock leadership is very narrow and outperformance from stock selection required being in a small set of companies. If, or maybe when, the AI theme loses its luster, I would expect large cap tech to cede its strength to its smaller brethren or to other sectors. Now, a surprise winner in Q2 was utilities. Utilities outperformed across all the Russell Value and Growth indices and was the top performing sector across all three of the value indices. Typically, utilities are bought for their defensive characteristics, which might provided a modest tailwind in Q2. Utility stocks also tend to do well when the 10-year Treasury yield is dropping, but we ended the quarter just about where we began the quarter in terms of the risk-free interest rate. The surprising driver of utility stock strength this quarter was none other than the AI trade. It seems we just can't escape that theme. Investors became excited about how power-hungry those AI chips are that are being placed into action and, eventually, the amount of power required as we run AI-optimized search and other new functionalities. The demand for power to run these chips is sparking expectations for accelerated growth in utility company revenues, specifically for independent power producers who sell power directly to the grid or to individual large consumers. The combination of growing demand and defensive cash flow characteristics might put this otherwise very sleepy category of utility stocks into the spotlight for the time being. Returning to the soft trends of consumer spending seen during the quarter, it's worth calling out the underperformance of the consumer discretionary sector, which underperformed the broad indices across both value and growth styles and across all market cap sizes. The pain was widespread and included underperformance amongst select distributors, restaurants, household durables, and auto components. The pain was initially most prevalent in businesses exposed to the lowest income consumer, but as the quarter progressed, evidence was presented to us that the challenges are moving up the income cohort group. This is definitely worth keeping an eye on since the consumer drives a large portion of the U.S. economy and, thus, overall economic strength. So, what should investors be watching for as we embark on the third quarter of 2024? Certainly, many eyes remain on labor and inflation. I continue to worry that the window for the Fed to proactively cut rates is closing, but their hands remain tied. Inflation is sticking above their 2% target and the fear of igniting another bout of rising inflation is far greater than the concern of pushing the U.S. economy into a modest slowdown. Equity market returns are typically not positive following the Fed's first interest rate cut, but this Fed does seem determined to create that soft landing investors have been hoping for. Time will tell if they can slip through the window before the economic clock winds down. I also continue to keep an eye on the very high concentration levels within the most commonly used index, which is the S&P 500. The top ten stocks make up over 30% of the index. These are world-renowned businesses that have proven themselves to be good growers and highly profitable. But if there were a flow of money out of equities for any reason, it is seemingly safe to assume that those largest positions will feel the weight of that exodus. What that means for the small and mid-cap stocks is not entirely certain to me, but at a minimum, investors should be thinking about their allocation to specific indices and making sure they are comfortable with the concentration of risk and deciding if now is the time to resize their allocations. Finally, I continue to focus on a large amount of debt that is coming due over the next 24 months. The majority of that debt was priced at much lower interest rates than are currently available, meaning companies will either need to consume cash to pay that debt down or resign to the fact they'll be paying higher interest expense on the debt as they refinance it. Neither option is ideal when it comes to companies having available funds to grow through M&A, invest back into the business, or pay dividends. Over the last decade, balance sheet strength might have been an underappreciated asset—pun intended—as interest rates plummeted and low cost debt was available to every company. But now, as rates remain higher for longer, the power of financial freedom, as measured by a well-built balance sheet, could be the key to stock selection success. Let's not forget a tremendous amount of debt is in private credit and private equity where visibility is limited. Could this be the contagion that creates the next crisis or will we skate by with only a few blips on the radar? Indeed, the economic and market winds are beginning to shift. Investors have plenty of reasons to think long and hard about how they are currently allocated amongst the various equity categories. And importantly, how do you want to use the unique investment process of your active managers to mitigate risk and drive future returns? Thank you for listening to our second quarter 2024 recap video. Please reach out to your Allspring Global Investments contact person if you'd like to have additional conversations.