Investor sentiment in US equity markets has improved notably in recent months as pessimism surrounding the tariff rhetoric from the new US administration moderated to more of a wait-and-see approach. What does that mean for US small-cap stocks with the market recovery now well under way, asks Vincent Nichols.
Markets still face plenty of uncertainty, largely hinged around trade policy, but some of the worst-case outcomes now look more unlikely. Investors may be more inclined to look past this issue if the trade negotiations continue to progress. US stock markets could draw further support from the probability of tax cuts, partly funded by revenues from the import tariffs.
Recent inflation data has been benign, but the impact of tariffs (at any level) is not yet reflected in the numbers. US businesses built up their inventories in anticipation of the implementation of the tariffs, but imports slowed substantially in the second quarter.
Until the high inventories are wound down and import volumes recover, uncertainty over the tariff impact on consumer prices will likely persist.
We believe the near-term trajectory of the economy and markets is still going to be influenced heavily by developments in the trade war, but investors have increasingly shifted their focus back to fundamentals as they await more concrete evidence on the economic impact of the trade policy.
So, are we likely to see more rate cuts?
The US economy was decelerating already before the tariff announcements, so even in a more benign trade policy environment, growth may remain challenged.
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 the fed funds policy rate is still in restrictive territory at well above 4%. However, investors worry that potential price pressures from the tariffs will handcuff the Fed’s ability to manoeuvre.
Even so, interest rate cuts by the Fed would likely only be delayed. Implied inflation expectations (as per one-year breakeven inflation rates; see Exhibit 1) have fallen by more than 1.5% to 2.6% from their peak earlier this year, indicating scepticism in the markets that higher tariffs would cause a material reacceleration in inflation.
Long-running support for small caps
In the intermediate term (or in the short term if the impact from the tariffs is milder than expected) the secular drivers that we see for small capitalisation shares remain in place.
After Donald Trump’s re-election, many US small-cap stocks rallied sharply on expectations that the new administration would focus on reinvigorating domestic industrial activity and implement company-friendly policies such as deregulation and tax cuts.
So far, the actions of the administration have been consistent with this framework, but it will likely take much longer for the effects to appear in the data.
Over the last two years, US growth has been more resilient than expected, largely supported by robust consumer spending, a healthy labour market and real (inflation-adjusted) growth in wages.
At the same time, aspects of cyclical momentum have been in a protracted multi-year downturn. The slowdown that we’ve now entered into may be setting the stage for an eventual 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 capitalisation (tech) companies may finally be at hand.
The small and medium-sized company sector is more diversified than large caps and its share performance is more highly correlated with cyclical momentum. Small-cap net income is down by more than a third from its peak in 2022, so we believe there is ample opportunity for a pronounced recovery in earnings growth from these low levels (see Exhibit 2).
Lower policy rates, even if delayed, should help improve stagnant loan growth, and help lower both the US fiscal burden and the interest expense for companies (especially smaller companies). It should also revitalise depressed merger & acquisition activity.
Focusing on innovation in healthcare
We see abundant innovation in the small-cap segment, notably in the healthcare sector.
After all the genetic sequencing of 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 combine antibodies with chemotherapeutic payloads, and harness the immune system by returning T-cells engineered to attack cancer cells to 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 been able to pick winners over the last decade and a continued recovery in biotech should benefit the strategy disproportionately 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 have often paid substantial takeout premiums.
A combination of likely rate cuts, boardroom optimism and a measure of economic stability could lead to more widespread and vibrant M&A. That would be another tailwind for small caps – it would support valuations and open opportunities for high-premium takeouts in our strategy’s portfolio.
