Small-cap stocks in the US haven’t presented the most appealing investment opportunity in recent years, especially when compared with the impressive performance of their large-cap peers. But the asset class began to catch the eye of some investors last year as it appeared increasingly likely the inflationary headwinds that had hindered smaller companies would soon recede, paving the way for a more supportive environment in which they could thrive once more.
That was, until the prospect of widespread tariffs threatened to bring a new bout of inflation to the US economy just as the US Federal Reserve was hoping to get it under control. Laura Cooper, global investment strategist at Nuveen, forecast that a broad 10% tariff would add 0.3 percentage points to core inflation in the US, giving her pause for thought when it came to re-allocating to small caps.
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“We became more constructive on US small caps in the fourth quarter of last year, and this was largely reflected by US exceptionalism and the fact that we were likely going to see a broadening of opportunities in the US. But we’ve tempered that view more recently, and that largely reflects the uncertainties we’re seeing on tariffs,” Cooper says.
“If we start to see that spill over into consumer sentiment becoming depressed on the back of policy uncertainty, that could have knock-on implications for small caps. Inflation has already weighed on their bottom lines, so a further inflationary impulse from tariffs is going to hit those small-cap companies that don’t have the cushion to absorb it that many of the large-cap companies do.”
Small talk
This is echoed by Tara Fitzpatrick, manager of the Schroder Global Multi-Asset range, who says smaller companies are “especially economically sensitive”, making their performance highly reliant on the US’s overall economic growth and liquidity cycles. She has not had a meaningful exposure to the asset class since 2021, but took a tentative step back into US small caps after Donald Trump’s re-election in November.
Yet that position was only held for a month and was a short-term, tactical bet based on sentiment rather than a long-term return to the asset class.
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“That was very much a Trump trade, but if you look at the environment today as a whole, the cycle is still very challenging for small-cap stocks,” Fitzpatrick explains. “We have a pretty hawkish Fed, interest rates are much higher than they were previously, and the liquidity environment is just not as supportive. And tariffs are a big challenge for small caps.
“They are debt-reliant businesses that are very dependent on easy financing. Add in a layer of inflation concerns from tariffs to that, and it threatens that easy interest rate environment and makes the business models of those companies quite challenging, because a lot of them are simply not profit-making. It’s quite hard to have a structurally positive view on small caps because of that.”
Read the rest of this article in the March issue of Portfolio Adviser magazine