While value stocks and small caps are forecast to be market darlings in 2024, investment executives say renewed fears of an economic slowdown could complicate that outlook.

The last week of July showed initial signs of optimism, with the Bank of England cutting interest rates for the first time since 2020 and Australia and the US reporting cooling inflation.

However, equity markets were in the red by Friday as fresh economic signals from the US fueled investor concerns that central banks “may have given up too late”, according to AMP chief economist Shane Oliver.

"There are renewed fears about economic growth," he told InvestorDaily.

“While our stock market saw lower than expected inflation on Wednesday [following the latest inflation data]and continued to rise on Thursday, those gains were largely reversed by a poor signal from global equity markets.

"Initially there was this rotation from technology to other parts of the market, but I guess now investors are worried [that] these other, more cyclical parts of the market, such as small caps, could be vulnerable if growth slows too much.

Overnight, the Russell 2000 was down 3 percent from Friday AEST, he noted, while the Dow Jones fell 2.1 percent.

The ASX also posted its worst daily performance in almost 18 months, falling 2% by the close of trade on Friday 2 August.

Describing the moves as a "growth scare" in what is typically a weaker market season in August and September, Oliver acknowledged that rising geopolitical risks stemming from the US election and events in the Middle East raised concerns that this market correction "could to last a little longer”.

Looking at the outlook for small-caps, which looked poised to benefit from rate cuts in 2024, Oliver said much would depend on whether global markets, including the US and Australia, are able to withstand a soft landing.

"In the past, rotations could support equity markets for a little bit longer, ultimately it depends on whether we go into recession or not," he said.

"My best case is that we avoid a recession and therefore the rotation will help the markets even though technology has started to pull back." But I have to say that I feel nervous about it because the things that people were talking about in terms of the recession two years ago are still there.

The yield curve in the US and Australia remains inverted, he explained, while the leading indicator for the US has fallen for almost two straight years, and there have been "gloomy" jobs indicators coming out of the US recently.

"Growth concerns would sink any rotation in the short term, but hopefully if we avoid a recession - which I think we probably will, but it's something I'm still concerned about - then the rotation will start again," Oliver added .

Interpreting signals

Joe Unwin, head of portfolio management at Apostle Funds Management, explained that markets appeared spooked by early signs of a slowdown in economic activity, with Australian share markets absorbing much of this negative sentiment in trading.

That could potentially translate into flows to small caps, at least in the short term, as people look to sell growth stocks, he said, although the question remains "whether the negative returns in these growth stocks are offset by positive returns in small caps or value stocks'.

"I suspect the buying of these small caps is going to be done a little more value-wise than it was in the growth stocks, so if the markets are right and there's a slowdown in growth, you won't necessarily see a big rally in these small caps." or value. You will certainly see a lot of outperformance against growth stocks, but they may have more modest returns than you would expect in a rally,” he told InvestorDaily.

On the contrary, if the growth figures turn out to be "not too bad", then buying interest could turn into a strong small-cap rally.

"But I suspect it would be a lot less sharp than you would see in the growth space," Unwin said.

"It probably looks more like a medium-term period of good returns than a short period of really high returns."

Like Oliver, the investment executive believes markets will be closely watching the US Federal Reserve's next move and may be waiting for a "green light."

"I think looking at the data last night, it gave people confidence that if anything the Fed may have kept rates higher for longer than they should have, and that they're almost certainly going to start cutting rates -- which is kind of a green light for these small-cap stocks,” Unwin said.

Ultimately, he continued, a lot of investor sentiment will come down to whether rate cuts are driven by inflation or growth concerns. The former could prove promising for growth stocks, indicating lower inflation, while the latter could usher in value and small caps.

“Normally a rate cut would be good for growth stocks, but you could argue that they've already priced in the rate cuts. Falling interest rates due to an economic slowdown is bad for investor sentiment, and indeed growth stocks are valued based on good investor sentiment,” he said.

"As soon as investors start to get nervous, those stocks that are priced really high have a long way to go if that optimism goes away, while small caps are priced with little optimism." They are priced conservatively, so they will do much better when rates start to fall.