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2022 outlook: 'Small caps are the economy,' strategist says

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Francis Gannon, Co-Chief Investment Officer at Royce Investment Partners, joins Yahoo Finance Live to discuss the outlook for small cap stocks for 2022.

Video Transcript

- --live. First trading day of the year, and we are seeing all three major indices in the green so far. We saw the Dow dip into the red, but it is trading pretty flat right now, the NASDAQ seeing the biggest gains so far, up about 101 points. We're keeping a close watch as well on Treasury yields here. Take a look at where the 10-year is, pushing above 1.5%, and the 30-year inching closer to that 2%-- or it's right at that 2% level. Certainly inflation concerns, and the Fed's rate hike clouding the outlook for a lot of investors as they look ahead to this new year.

Our next guest says small caps are the place to be in the face of all those uncertainties. Let's bring in Francis Gannon, Royce Investment Partners Co-Chief Investment Officer. Francis, happy new year to you. Walk me through your thesis here on why you think small caps are going to regain the lead.

FRANCIS GANNON: Good morning, and thank you for having me. I think part of the opportunity here with small caps is the fact that they haven't done as well as some of the other asset classes. Small caps today are about 8% below their most recent high, and yet fundamentals for many of the businesses continue to improve. And I the best way to think about small caps in the year going forward is small caps are the economy, especially domestically here in the United States. And so you should see broad participation, something we haven't seen in other indices as well. In fact, if you looked at the equal-weighted-- so Russell 2000's performance last year versus the cap-weighted, you would have seen it have done actually much better than the overall index.

Same thing-- the opposite is actually happening in the large cap indices, where you see the cap-weighted indices actually underperform the equal-weighted. So we know that most of the performance in the large cap space is coming from you know, five stocks in the Russell 1000. And at the same time, what you're seeing in the Russell 2000 and small caps in general is a broad participation. So as the economy continues to improve, we believe you're going to continue to see valuations close here for the small cap perspective. And I that's part of the opportunity going into this year.

- It was interesting to kind of see that early bifurcation between small caps and some of the big tech mega caps right after kind of the first wave of-- of COVID-19 way back when in 2020. And when you think about maybe what's ahead, as Akiko was talking about, the rate hike expectations out there, obviously, as we've talked a lot about on this show, generally tends to not favor some tech names. I mean, how do you see that maybe changing things up in 2022 when you dig into which specific small caps you might be most confident in?

FRANCIS GANNON: Yeah, so I think that's a really important point, Zach, is I think is if you continue to see rates move up, and you see the Fed begin the taper, you're going to see those long duration assets underperform. And I think as the economy continues to catch up and earnings growth continues to expand, and I think that's effectively what's happening these days, is you're going to see a much broader participation within the overall market. So outside of those top five names within the Russell 1000 or S&P 500.

And so as I look to the small cap space, yes, we're going to have increased volatility obviously around COVID and the latest variant. The effects of inflation, we're going to have volatility around taper. but at the same token, small caps are cheap on a relative basis, and that's the opportunity here. And within small caps, we continue to focus on the more economically sensitive or cyclical areas of the market. If you look at what performed best within the small cap space within the fourth quarter, it was industrials, financials, information technology. And I think those are the areas that represent great opportunity in a world where people are concerned about inflation wage pressure, et cetera. These are areas that I think represent good opportunity within the small cap space.

- As you look ahead on this first trading day of the year, what do you see as the biggest risk right now? Is it really all about the Fed? Is it about political uncertainty with midterms on the horizon-- yes, not until months later, but certainly, we know those things start to play out early on in the year. You know, what-- what do you see as the biggest risk, and then also, the risk that you think a lot of investors are overlooking?

FRANCIS GANNON: So I think one of the-- I think you're-- you're right. All of the things you just mentioned are risks to the market this year. And there's always going to be some out-of-left-field event that we don't actually think about that is going to be the primary risk of the year. But I think volatility is just going to be higher this year than we saw last year. I think one of the things that people aren't thinking about is in the small cap space, we've had three double-digit return years in a row, something that we've only seen twice before in the history of the Russell 2000. The last time we saw it was back in the mid-90s, '95 through '97. And we tend not to see that fourth year of double-digit returns.

So I think you're going to see more muted returns in the market this year, not as strong as we've seen in the past year. You're going to see more volatility. But I do think small caps have an edge here over their large cap brethren here just because of the fact that you're going to see very strong earnings growth in a much broader market.

- You know, let's just talk one last piece of that thesis, too, and we think about the big story in 2021 about [INAUDIBLE] inflation, and that expected to continue. We're just tracking with the Council of Economic Advisors who joined us here to start the show, and it does seem like a lot of those pressures are going to continue. When it comes to the ability to pass along some of those price increases to consumers though, how do you look at that being different for some of the bigger names maybe outside of tech, but just in CPG and maybe some of the I guess smaller names out there, how they can weather that storm?

FRANCIS GANNON: So great point, Zach. I mean, if you go back and you look over history in inflationary periods, small caps outperform most of the asset classes. And I think that's another great opportunity for looking at the small cap space this year. And part of that is small cap companies have the ability to pass on these pricing pressures faster than large cap companies. Are a little bit more agile, given their size, and so they're able to take advantage of the pricing situation. And that's what we're hearing from our companies right now in our portfolios. So inflation is actually something that I think benefits the small cap story and I think it also benefits active management. And you're going to see active managers continue to outperform here in the small cap space going forward.

- OK, well, we'll be watching to see if that thesis holds. Francis, it's good to talk to you today. Francis Gannon, Co-Chief Investment Officer at Royce Investment Partners.

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