What Could the Midterms Mean for Small-Caps?

What Could the Midterms Mean for Small-Caps?

Much Ado About the Midterms? Royce managers offer their insights about the investment implications on small-cap stocks.

There have been a lot of positive developments that will arguably have more lasting effects on the economy and the markets than the results of what has to be the most over-analyzed midterm election in our history.
Bill Hench

Rob Kosowsky: The consensus view regarding the outcome of the midterms is that we’ll have a divided federal government, with the Democrats taking control of the House of Representatives while the Republicans hold on to a slim majority in the Senate. That sounds about right, though we’re obviously not in the business of forecasting elections. Our job is to think through the event to where we might find the most attractive investment opportunities.

And I think from an investment standpoint, divided government would be a positive outcome because it’s likely we’ll see a stalled legislative agenda, and gridlock is often good for companies. It creates more certainty and stability because businesses aren’t worried about new laws or regulations that often lead to increased implementation costs or taxes.

In this kind of environment, tax rates are also probably going to remain unchanged at the corporate level—and the current status quo has so far been favorable for small-caps, so I see that as another plus that would result from legislative crawl.

A more predictable macro backdrop may be even more important for companies undergoing turnarounds. These companies are sometimes in pretty fragile condition as they improve or rebuild their business, so a more stable legislative and macro climate can be a big help because it allows them to focus more completely on the process of becoming successful again.

Suzanne Franks: If as expected the Democrats take the House and Republicans hold the Senate, I’m not quite as sanguine about the prospects for gridlock. I think a Democratic House will advocate for tax increases and for changes to the current regulatory environment.

It’s possible that these efforts could result in new legislation—but even if they don’t, they could still create transitory trouble for companies. Any corporate tax increase would obviously do the same. So that’s definitely a concern for me.

On the other hand, I think a Democratic House will be good for infrastructure spending because they’re very likely to make it one of their priorities, which for us would be a positive. We’re often looking for opportunities in construction, engineering and related areas regardless of the political climate.

Trade remains an important area, but because those policies come primarily out of the Oval Office, I’m not anticipating any significant changes there.

Bill Hench: I think there are four factors that we all need to keep in mind before considering the results and effects of the midterms: Housing, manufacturing, infrastructure, and Capex spending.

Housing has been a drag on what’s otherwise been a solid recovery over the last couple of years as rising rates and affordability have combined to slow progress. The fact that this drag has not been driven by too much inventory is actually good news—it suggests that the market for homebuilding can recover relatively quickly, which is one of the reasons we like housing-related stocks over the long term.

The economy has added about 400,000 manufacturing jobs over the last two years, which I think has been an underappreciated bright spot and an indication that the rebound can continue. Think of how long and slow the respective recoveries were for both tech stocks after the Internet Bubble and housing stocks following the Financial Crisis. I think we’re in the early stages of the same kind of prolonged recovery for manufacturing.

As for infrastructure, I think the longer we go without a major federal highway bill, the bigger that bill is going to be. And we’re already seeing larger-scale projects at the state level. We’re also seeing some significant spending on CapEx that’s been the direct result of lower corporate taxes—and this has helped certain holdings.

Another positive is the ongoing robust demand—which is global—for technology in areas such as automation, AI, and cloud storage. There’s simply too much pressure on companies to keep innovating, in my view, for this to slow for very long.

So that leaves us with a lot of positive developments that will arguably have more lasting effects on the economy and the markets than the results of what has to be the most over-analyzed midterm election in our history. The recent market declines are also probably more important.

 

Investments in small-cap and mid-cap companies involve a higher degree of risk and volatility than investments in larger, more established companies.

 

 

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