Do smaller stocks protect us from inflation? This is the question posed by the fact that the FTSE small cap index has risen by over 60 per cent since September at the same time as inflation expectations have risen. In fact, so great has been the rally in small stocks that they are now at their highest level since 1989 relative to the FTSE 100.
There’s plenty of precedent for small caps doing well when inflation expectations rise. The same thing happened in 2009-10 and in 2013 for example. And, conversely, falling inflation expectations in 1991-92, 1999 and 2008-09 also saw small caps do badly. Small caps have also tended to do well not just when the gilt market’s inflation expectations rise but when commodity prices do so as well.
We should not, however, infer from this that small caps are a good protector from the threat of inflation.
Instead, what this tells us is that small caps are more cyclical than larger ones. They do especially well when the economy recovers, which is when inflation expectations rise, but badly in recessions which is when inflation expectations fall.
It’s no coincidence therefore that small caps have recently done well at the same time as value stocks have outperformed. Both segments of the market are cyclical, and we have enjoyed a cyclical upturn.
In fact, it’s likely that serious inflation would be bad for small caps. Three facts about their past returns tell us this.
First, high interest rates lead to small caps doing badly: the double-digit rates of the early 1990s, for example, led to massive underperformance. This is partly because higher rates lead to fears of slower growth to which small caps are unusually sensitive, and partly because some small caps are more dependent upon external finance than larger stocks, many of which are sitting on big cash piles.
Small caps might withstand rising rates, because the strong economy that causes the Bank of England to tighten monetary policy is good for them. But, eventually, higher rates have an impact.
Secondly, small caps have tended to underperform the FTSE 100 at times of rising equity market volatility (as measured by the Vix index). This shouldn’t be surprising: small caps are more sensitive to investors’ appetite for risk, and higher volatility is a sign of higher risk.
This implies that if inflation were to become so great a threat as to unsettle global equities, then smaller stocks would suffer.
Thirdly, small caps are sensitive to something else – policy uncertainty, as measured by Scott Baker, Nick Bloom and Steven Davis. When their index of policy uncertainty rises, small caps underperform, as we saw in 2001, 2003, 2008, 2016 and 2018. And when policy uncertainty falls, small caps do well, as we saw in 2009-10 and 2015. The last few months fit this pattern: small caps’ good run has coincided with a fall in policy uncertainty.
There are good reasons for this link. Small caps are less diversified by country or business line than many larger companies and so are more vulnerable to bad policy. And policy uncertainty can itself depress economic activity by encouraging companies to postpone expansion plans until the fog lifts – and a weaker economy is bad for small caps.
This poses another danger. If inflation rises significantly above its target we’re likely to see increased uncertainty about how far the Bank raises rates or whether the government will change the inflation target. This would be worse for smaller stocks than bigger ones.
Through these mechanisms, a serious inflation scare would be bad for small caps.
You might object here that you don’t hold small caps generally – few of us have ETFs that track small cap indices – but rather specific ones. This doesn’t get you off the hook. In the last few months, small-cap investors have been fishing in rich waters. If inflation rises, however, the waters will become barren and you’ll have a much tougher jobs of stock-picking.
But will inflation become a serious danger? Personally, I suspect not. Yes, it will rise in the next few months. But this will be because of base effects (such as last years’ cut in VAT on hospitality trades dropping out of the numbers) and temporary mismatches between supply and demand. If so, small caps should hold up, as ongoing non-inflationary growth is good for them.
Sadly, however, we should never base our investment strategy upon a forecast. For one thing, I might be wrong. And for another, even if I am right investors might mistake temporary inflation for a serious problem – in which case small caps would suffer. Investors in them should therefore brace themselves for a rough ride.
