Higher wages, not inflation, is the bigger risk to small stocks right now, BofA says

Higher wages, not inflation, is the bigger risk to small stocks right now, BofA says

April 13, 2021

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  • Small-cap stocks could perform well against large caps in this environment of rising inflation, said Bank of America on Tuesday.
  • While small-caps could do well with the CPI under 4% a larger risk would come from wage pressures.
  • Small caps remain inexpensive versus large-cap shares, the bank said.
  • See more stories on Insider's business page.

Wall Street is staying alert over an expected jump in consumer price inflation but a climb in wages would be the bigger risk to small-cap stocks, according to Bank of America.

Inflation is set to pick up over the next few months as the US economy recovers from the COVID-19 pandemic, aided by vaccines and trillions of dollars in fiscal stimulus from the government.

Bank of America in a Tuesday note said its work looking at inflation and equities indicates that small-cap stocks outperformed in the late 1960s, and that its global strategist "sees as a historical analog."

From a valuation perspective, a rise to more than 3% in the US consumer price index this quarter – and sticking close to that level over the next few quarters – "isn't necessarily negative for multiples," as history suggests there's little relationship between inflation and price-to-earnings in environments when inflation is running below 4%.

The CPI rose to 2.6% in March year-over-year, largely pushed up by a 9.1% leap in gasoline prices, the Labor Department said Tuesday. Inflation was running slightly ahead of the 2.5% consensus estimate from Econoday.

"But a big pick-up in wages would be a risk," as small caps are two times more labor intensive than large caps, saidJill Carey Hall, a US equity strategist at BofA, in the note.

Average hourly earnings at private employers in March was $29.96, up by 4.2% from the same month in 2020, according to data from the Bureau of Labor Statistics.

An increase in capital expenditures amid higher commodity prices, however, should benefit sales at small-cap companies more than those at large-cap companies, the firm said.

Small caps remain inexpensive compared with large caps across measures that Bank of America said it tracks. They trade at a 12% discount to large caps "when historically they've traded at a 3% average premium," said BofA. It recommended investors "stay cyclical," with small-cap financial and energy shares offering the biggest relative valuation opportunity compared with their large-cap peers.

The Russell 2000 index of small caps has bulked up by nearly 80% over the past 12 months. It's up nearly 13% year-to-date compared with the 10% gain for the broader S&P 500 index.

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