Small caps set for resurgence with softening of inflation: Atchison’s

Toohey notes that on top of softening inflation, small caps will also be buoyed by enhanced consumer sentiment and a better lending environment. “The sector now looks extremely attractive,” he says.

As we reach the apex of the inflationary cycle, Atchison Consultants predicts a “resurgence” in Australian small cap stocks, which have underperformed of late but should be set to benefit from easing economic conditions.

Softer inflation, which will allow the Reserve Bank of Australia to ease back on interest rates, would theoretically allow for more generous allocations of capital in the domestic market and a more accommodative environment for companies in the $50 million to $500 million market capitalisation range.

Yet backing small caps at this point is nothing if not an act of faith, given the sector’s recent performance. After a steep 20.7 per cent decline in 2022, the ASX Small Ordinaries Index experienced only a modest 4.72 per cent gain when the rest of the market soared in 2023.

Atchison Consultants principal Kevin Toohey (pictured) tells The Inside Adviser these results need to be put into a cyclical context. Both in 2014, when small caps declined -6.8 per cent, and in 2018, when small caps tanked -11.3 per cent, they then experienced three consecutive years of positive returns.

“The Australian Small Cap sector (ex-ASX 100) has underperformed its Large Cap (ASX 100) counterpart by 24 per cent since the start of 2022,” Atchison notes in its Q1 Tactical Allocation Outlook paper. “The sector now looks extremely attractive, with higher earnings growth available at a significant valuation discount.”

Toohey notes that on top of softening inflation, small caps will also be buoyed by enhanced consumer sentiment and a better lending environment.

“2023 saw negative sentiment [affect] Australian small companies, yet with signs that financial conditions are easing, inflation is moderating and interest rate rates have peaked, we see a favourable environment for the Australian small caps market to outperform in 2024,” the paper states.