The Fed’s recent hawkish tilt has sparked volatility across risk assets, particularly in those sectors and asset classes with relatively greater sensitivity to higher short-term rates, such as small-cap and long-duration stocks. While the major indices have held up fairly well relative to historical standards, a much different picture emerges when we peel back layers of the onion. According to data from Bloomberg, the average drawdown for the average NASDAQ 100 and Russell 2000 constituent is 22.9 per cent and 37.7 per cent, respectively. Growth and thematic sectors have struggled even more.

Graph 1, Small-Cap Growth, 02.24.22

The recent drawdown has created an attractive entry point in small-cap growth stocks for long-term investors with a higher risk tolerance. Small-cap growth stocks provide exposure to some of the most innovative and thematically compelling companies in public equity markets. Stickier-than-expected inflation and the recent Fed pivot have not derailed technological innovation or disrupted megatrends.

Here’s how small-cap growth stocks stack up across fundamentals, valuation, and technicals:

Fundamentals

The US economy should continue to normalize in 2022 with growth stabilizing around 2.5-3.5 per cent, underpinned by a strong consumer, improving labor conditions and increasing business investment. We also see inflation starting to roll over in Q1 as global growth moderates and supply-chain constraints ease. We believe the Fed will hike rates three times in 2022, fewer than the current market consensus of four to five rate increases. Expect increased volatility as investors anticipate the Fed lift-off in March and grapple with the uncertainties of the new landscape. In the near term, the market appears overly hawkish and any pivots could result in a “rubber band effect” as small-cap growth names snap back. Once investors shift their attention to the portfolio implications of the slowing global economy, they will focus again on growth stocks with above-market growth profiles. However, we highlight these stocks tend to have higher volatility, higher beta and greater sensitivity to interest rate moves.

Valuation

The recent re-rating in small-cap valuations (particularly small-cap growth) has happened at an historic pace. Absolute P/E ratios have compressed to levels not seen in over a decade, and small-cap growth is trading at its largest-ever discount to US large caps. While we believe valuation is not a good short-term timing tool, it can provide guidance for longer-term entry points.

Graph 2, SC Growth

Technicals

When viewed in terms of relative year-on-year returns, the Russell 2000 Growth Index has had a three- standard-deviation move relative to the S&P 500. This suggests to us that bad news is priced in, leaving room for upside surprises. A reversion to the average would suggest a potential relative return for the Russell 2000 Growth Index of roughly 40 per cent vs the S&P 500. Current negative price momentum, although a powerful force, is somewhat offset by what we believe is overly bearish sentiment – providing an opportunity for a contrarian entry point.