International Small Caps Offer Opportunities Amid Macro Challenges

Friday 3 December 2021


Author: Maha Khan Phillips

Despite short term challenges, there are many structural and scalable equity market growth opportunities available, especially for small- cap investors, argues Aidan Farrell

International small-cap stocks are currently  trading close to their all-time highs, as measured by the MSCI EAFE Small-Cap Index, which has risen over 10% in USD terms so far in 2021. These returns have outpaced the international large-cap MSCI EAFE Index year-to-date (FactSet as of 26 October 2021), mirroring the multiyear outperformance of small-cap versus larger-cap international equities. (Exhibit 1.)

chart, small caps, 20 years

Recovering from their lows of early 2020, equity indexes marched relentlessly higher into the first quarter of 2021, powered by the post-vaccine COVID recovery trade combined with massive monetary and fiscal stimulus measures. Since April, however, stocks have struggled to progress. Once-exuberant market sentiment has moderated considerably as investors now grapple with possible economic scenarios ranging from reflation to stagflation.

Strategists, analysts and the financial press are focused on cost pressures – in the form of higher wages, a lack of available workforce, rapidly rising input costs such as energy – and their possible impact on profit margins. We expect this debate (structural versus transitory inflation) to rage for quite some time. In our view, near-term demand/supply constraints need to normalize and pandemic unemployment payments need to be rolled back before we can truly assess whether inflationary forces are real.

We believe investor concerns are not without merit as we consider the growing list of challenges:

  • Stretched stock market valuations. This is occurring as we move from an early-stage COVID-19- related economic recovery to a more mid-cycle phase, with a recent slowing of economic growth expectations.
  • Supply chain bottlenecks across the globe. Supply chain issues continue to stall product deliveries and disrupt production. Meanwhile, a severe shortage of truckers, dock workers and other personnel is compounding the problem. Collectively, these are affecting wages and the prices of materials, contributing significantly to inflationary pressures.
  • Soaring energy prices and wage pressures. Concern around these issues is front and center –  stoking inflation and dominating media headlines. (See Exhibit 2.) Giant consumer products company Unilever announced price increases of 4% or more for this year and next. The outstanding question remains as to whether those inflationary pressures are transitory or entrenched.
  • Less supportive monetary policy. In light of the global recovery and inflationary concerns, it now appears likely that central banks will begin removing support. Peripheral central banks have already started to increase interest rates. Tapering of asset purchases by the Federal Reserve appears imminent and the first increase in U.S. interest rates in three years is now being priced into the markets. Meanwhile, the Bank of England is expected to raise rates by 15 basis points to 0.25% in Q1 2022, if not sooner, according to a recent Reuters poll.
  • The path of COVID-19. While enormous progress has been made in the fight against the global pandemic, the war is not yet won. New COVID variants are a constant threat and uncertainty remains as to how long vaccines will remain effective until boosters are required.
  • The political narratives in China and Russia. Tighter government regulations across numerous industries in China, and Russia’s control of gas supplies as it relates to Europe, are added sources of uncertainty.

Exhibit 2: Coverage of supply chain issues has dwarfed coverage of demand recovery


While a list of challenges naturally leads to a degree of caution, we believe any resultant volatility plays into the hands of stock pickers. Should the investment environment deteriorate, strategies which focus as much on capital preservation as on capital appreciation should prevail.

While only time will tell what the truly long-term implications of the global pandemic will be, it already seems clear that certain sectors will be challenged in terms of their business model for some time to come. A classic case appears to be the airline industry. The work environment created by COVID-19 shone a light on the amount money and time spent on business travel pre pandemic — at least some of which has appears to have been unnecessary, if not wasteful. Moreover, the more long-term issue of climate change will no doubt impact the airline sector, as well as the broader transport industry, among others. In our view, some business models will need to change, hopefully in a positive direction from an environmental, social and governance (ESG) perspective. Nevertheless, with structural change comes heightened uncertainty, which we believe is typically best watched from the sidelines.

We think it more prudent to deploy investors’ money where we see greater certainty and structural growth in place. Some areas where we believe opportunities exist include:

  • Translation services, which increasingly are being outsourced. Here, we do not mean simple translation for holiday events for friends and family. Rather, consider the pinpoint accuracy required when translating details of drugs being developed, approved, and marketed across multiple jurisdictions and regulatory authorities, where there is zero room for error. Or, consider transcreation, where, for example, a major international consumer goods or technology company which wants to launch a new product in Japan, Germany, France, the U.S. and the U.K. at the same time. The messaging needs to suit different markets, different cultures and is not simply a case of translating each word and applying “copy and paste.”
  • The luxury goods sector is a well-trodden and profitable sector for investors when viewed historically. Currently, our research shows that U.S. consumers’ per-capita spend on luxury watches has fallen well below that of other developed countries, such as the U.K., despite the fact that it used to be on an equal footing. We believe this spending gap reflects a less-than-ideal market structure and marketing approach in the U.S., which is starting to change. We see one attractive company pioneering that change.

The point with these examples is that —  if you look beyond the near term (which can be distracting and tends to be the focus of market commentators) — we believe there are many structural and scalable growth opportunities available, whatever the investment environment. This is especially true for small- cap investors who have a broad investment universe from which to choose.  We believe the soundest approach is to be disciplined in evaluating near-term risks and opportunities, while remaining focused on the long-term view.

Aiden FarellAidan Farrell  is Director of Global Small Cap Equity at Eaton Vance

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