Throughout the pandemic period, M2 money supply growth trends have done a pretty good job of predicting what core inflation will do 13 months down the road, observes Jack Bowers, editor of Fidelity Monitor & Insight.

If this continues to hold true, we could see core inflation drop below 3% by early next year. That would be a favorable development, not only for bonds and large-cap growth stocks, but also for mid-caps and small-caps.

Normally, smaller stocks get hit harder than large-caps whenever the economy is slowing, but there are several reasons why small-caps and mid-caps could perform at least as well as large-caps going forward:

  • A less hawkish Fed would make capital easier to obtain. In contrast with larger firms that issue bonds, smaller firms tend to borrow at the bank (or from private equity firms) more often, making their cost of capital higher, while limiting financing options. As such, any relief on the central bank front improves the situation much more for smaller firms than for large-caps.
  • Labor shortages and supply chain constraints are easing in tandem with inflation. These particular pandemic effects had an outsized negative impact on smaller corporations, which have lower profit margins and lower labor-efficiency compared with larger firms. So any relief on this front should also have a favorable impact.
  • A stronger job market than is typical for an economic slowdown suggests that consumer spending will remain relatively strong here at home, while foreign economies deal with a more adverse slowdown with unemployment following a more typical recession pattern. This may benefit smaller domestic firms, which tend to derive a greater share of revenue from domestic sales compared with larger firms.
  • The premium on smaller-stock valuations has turned into a substantial discount over the last ten years.

There are many reasons for this, which include the growing prominence of large-cap technology disruptors, Dodd-Frank (which made IPOs less practical for firms that wouldn’t debut in the large-cap segment), stagnant profit margins, an investor stampede into passive large-cap index funds, faster economic growth in foreign economies (where larger domestic firms often operate), and heightened recession anxieties that manifested prior to the pandemic.

But at this stage smaller stocks generally offer greater potential earnings growth than large-caps, and they do so at a cheaper price. Of course, any increase in small-cap exposure means greater portfolio risk, regardless of whether a recession is expected.

Relative volatility scores make this obvious. Fidelity’s large-cap blend funds average 1.04, versus 1.21 for mid-cap blend and 1.28 for small-cap blend. Over the last ten years that additional risk was not rewarded, but going forward it may be a different story.

As such, I think the extra risk of smaller stocks is now worth taking, especially in our Unique Opportunities Model portfolio, which normally has a significant stake in smaller stocks but has been in a relatively defensive position since late January. In this portfolio, we have established a new stake in Fidelity Growth Strategies (FDEGX) and Fidelity Small Cap Stock (FSLCX).

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