Investor sentiment in US equity markets has worsened over the past month with market momentum reversing sharply as optimism crumbled in the wake of the outburst of import tariff rhetoric. Market instability and volatility have risen materially. What does that mean for US small-cap stocks, asks Vincent Nichols.
If US tariffs on imported goods proceed as communicated on ‘Liberation Day’, they amount to an average rate of 20% plus – levels last seen over 100 years ago during the Great Depression and levels that would severely disrupt business activity and dent consumers’ financial health. This is likely still not fully priced into equity markets.
Should tariffs become a lever for negotiations that move towards more balanced trade policy, the recent market downturn may turn out to have been an overshoot. Stocks could quickly recover once such a course of events becomes apparent.
Arguably, the near-term trajectory of the economy and markets will be influenced heavily by each twist and turn in this US-incited trade war.
So, what of small caps?
As of mid-April, the market drawdown in small caps has been on par with previous mild recessions (see Exhibit 1), leaving investors at a crossroads: one path leads to recovery if the economy can avoid more than a modest slowdown in the coming quarters; a more pronounced slowdown or recession would likely lead to more downside.
In the case of a more pronounced slowdown or recession, we believe the US Federal Reserve has ample room to soften its monetary stance given that policy rates are still restrictive at well above 4%, but investors worry that potential price pressures from the tariffs will handcuff the Fed’s ability to manoeuvre.
Even so, to date, interest rate futures are pricing in four cuts in the fed funds rate by the end of 2025. Implied inflation expectations (as per one-year breakeven inflation rates) have fallen by more than 1% to 3.05% from their peak earlier this year. This indicates that market concern over the economy is trumping worries over an inflationary spike.
Long-running support for small caps
In the intermediate term (or the short term if tariff negotiations succeed) the secular drivers that we see for small caps remain in place.
These policy shifts may lead to
- a quicker path to lower US interest rates
- a more substantial shift towards domestic activity
- a widening valuation discount between large and small caps
- a more dramatic recovery in earnings.
Lower interest rates alone should help improve stagnant loan growth, lower the country’s fiscal burden, similarly reduce interest expense for companies (especially smaller companies), and revitalise already depressed merger & acquisition activity.
Over the last two years, US GDP growth has been more resilient than expected, largely supported by resilient consumer spending, a healthy labour market and real (inflation-adjusted) growth in wages.
However, many aspects of cyclical momentum have simultaneously been in a protracted multi-year downturn. The slowdown that we’ve now entered may be setting the stage for recovery, which investors often position for several months in advance.
In such a scenario, the much-anticipated broadening-out of earnings growth and market performance beyond large-cap (tech) companies may finally be at hand.
Focusing on innovation in healthcare
There remains an abundance of innovation in the small-cap space, notably across the healthcare sector.
After all the genetic sequencing done over the last few years, some of the most impactful innovations will now likely come from translating that work into drugs over the next decade.
Various techniques can now, for example, combine antibodies with chemotherapeutic payloads, as well as harness the immune system by putting T-cells engineered to attack cancer cells back into the body.
Advancements in gene therapy and gene editing and the ability to interfere at the RNA level are also creating opportunities.
Many active asset managers of US small caps have avoided early-stage biotech companies given their complexity and binary performance profile. Our strategy has managed to pick winners in this industry over the last decade and a continued recovery in biotech should disproportionately benefit the strategy relative to peers.
Healthcare mergers and acquisitions have picked up notably recently as large cash-rich pharmaceutical companies face patent cliffs and are looking to backfill drug pipelines. They often pay substantial takeout premiums.
The combination of likely rate cuts by the Fed, boardroom optimism and a measure of economic stability could lead to more widespread vibrant M&A. That would be another tailwind for small caps – it supports valuations and opens opportunities for high premium takeouts in our strategy’s portfolio.
