The outlook for US small-capitalisation stocks is better now than it has been for several years. The main reasons include the US interest rate cutting cycle (small caps tend to benefit), currently attractive valuations, the reshoring trend, and (expected) merger & acquisition activity, argue Geoff Dailey, Chris Fay, and Vincent Nichols.
Falling interest rates and small caps
The US Federal Reserve began its dovish pivot in September 2024 and continued loosening monetary policy in November and December. As shown in Exhibit 1, the performance of small-cap stocks is correlated with changes in policy rate expectations: When market expectations for the course of the Fed’s policy rate turn more dovish, small caps tend to outperform.
This phenomenon is likely a function of the cost of debt falling for small-cap companies which typically have a higher proportion of variable rate debt than larger-cap companies. Declining policy rates should also encourage merger & acquisition (M&A) activity as 2025 gets underway.
More recently, longer-term interest rates have risen. This is due to market expectations of higher economic growth in the wake of Donald Trump’s election as US president, expectations for higher inflation, and concerns over the impact of tax cuts on an already bulging US budget deficit. The Fed now also looks to have become more hawkish about the outlook for inflation.
While higher interest rates can be a drag on equities, they mostly reflect a strong economy. Combined with the boost to revenue growth from somewhat higher inflation, we believe higher profits should more than offset the higher cost of debt servicing for smaller companies.
Small-cap valuations – Attractive now
Price/earnings ratios for small-cap stocks have recovered from the lows and are now trading slightly above their long-run average of 16.7 times (excluding companies with negative earnings). However, relative to large-cap indices, small-cap P/E multiples look low, at currently more than 30% below average (see Exhibit 2).
We expect earnings to drive the next leg higher for small-cap shares. Analysts are looking for robust earnings growth: by 42% in 2025 and by 36% in 2026 compared to just 6% in 2024 (see Exhibit 3). That is ahead of the historical earnings growth rate of 15%.
While generally speaking, earnings forecasts are often optimistic, we believe that with a soft or no landing ahead for the US economy, they are not wildly off the mark. If the higher earnings growth rates are realised, valuations should improve.
Mega-cap tech’s lead expected to narrow
Four big tech companies (Amazon, Google, Meta and Nvidia1) generated the bulk of earnings growth in the US market in 2024. This contributed to the outperformance of the tech-heavy NASDAQ 100, the small-cap Russell 1000 Growth and, to a lesser degree, the broad S&P500.
Earnings for the ‘big four’ grew by 70% year-on-year in the second quarter of 2024, compared to just 6% for the remaining 496 companies in the S&P500. That gap is forecast to narrow (see Exhibit 4) and consequently so should the gap in stock market performance between the different indices.
1 Mentioned for illustrative purposes only. This is not a recommendation to buy or sell securities. BNP Paribas Asset Management may or may not hold positions in these stocks.
Tailwinds for small caps in 2025
For decades after China’s admission to the World Trade Organisation (WTO) in 2001, US companies focused on outsourcing production to lower-cost nations (such as China) to improve profits. Industrial production stagnated in the US, while it rose sharply in China.
We see potential for that trend to reverse in the coming years. During the pandemic, having supply chains and manufacturing far from home created widespread difficulties for US firms and many are now looking to ‘re-shore’ production.
Rising geopolitical tensions and protectionism are other catalysts, backed by financial support from the US federal government’s CHIPS Act and the Infrastructure Investment and Jobs Act.
We believe re-shoring initiatives will drive a cycle of capital expenditure for many years ahead. US small caps should benefit as they are more levered to domestic investment and economic trends.
Information technology spending on datacentres – key to the infrastructure supporting the artificial intelligence (AI) ‘arms race’ – is boosting not only sales of advanced graphic processing units (GPUs), but also revenues at many lesser-known hardware, software, industrial, materials and even utility companies.
This spending is funded largely by the profits of other tech companies that are investing to grow their business, rather than hoarding cash or boosting earnings per share (EPS) via share buybacks.
M&A is another potential tailwind for small caps. As optimism over the outlook for the economy rises and political uncertainty fades, deal flow should improve. Strategic buyers are always evaluating opportunities for innovation or disruption and may now move towards implementation.
Conclusion
We see several tailwinds for smaller US companies emerging with monetary policy less restrictive, as earnings recover, and valuation dislocations normalise.
These market inflections could be supported further by trends in onshoring and re-shoring, and a resumption of M&A activity.
To us, the future looks brighter for small-cap stocks than it has in some time.
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