Talking Heads – US small caps: looking beyond the near-term uncertainties

This is an edited audio transcript of the Talking Heads episode US small caps: looking beyond the near-term uncertainties

Daniel Morris: Hello, and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing US small-cap stocks. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Geoff Daley, Head of US Equities.

Welcome Geoff and thanks for joining me.

Geoff Dailey: Hi Daniel. Happy to be here.

DM: Geoff, it’s safe to say expectations were pretty high post the US election at least for the outlook for US small-cap stocks, the view being that you potentially would see tariffs. Also looking for stimulus from the Trump administration focused on the US economy. We did see initially that the reaction of the small-cap indices was pretty good immediately post the election. That’s changed recently. What do you think’s going on?

GD: Post-election, small caps did rally a good 10% in a very short timeframe. There were clearly a number of counts in place even prior to the election. But Donald Trump’s win unlocked greater conviction. The pre-existing arguments for small caps included a record valuation discount versus large caps; resilient US economy; the Fed pivot; an impending M&A cycle and increased domestic investment.

The election results reinforced these positives and introduced a spectrum of deregulation, potential tax relief and a very pro-US growth agenda. So, for us, it wasn’t a surprise small caps rallied post-election. But as you said, small caps had a short-term peak in late November and have traded lower since.

There are a few drivers. For one, small-cap investor sentiment can be very sensitive to macro data, particularly metrics that can drive Fed policy and economic growth. Recently, we’ve found a few softer data points including lower retail sales, waning consumer confidence, and hot inflation.

For some investors, scepticism around economic growth and the threat of rate hikes if material re-inflation re-emerges has become a focal point. That sentiment puts pressure on small caps. At the same time, the frenetic pace of federal policy announcements has introduced another layer of uncertainty. The tariff threats, immigration policy, and federal government staff reduction announcements have unnerved some investors. I’d say lastly, generally after a long, solid run, there’s a period of consolidation. That’s not surprising. That’s what’s brought us to where we are today.

DM: Before the election, we were looking for a soft landing, meaning that US economic growth was supposed to slow. And it’s probably premature to think that’s going to turn around quite so quickly given that Trump’s only been in office for about five weeks. When we take all of this into account, has the story fundamentally changed for small caps for you? What should we expect now?

GD: Despite the near-term volatility and the recent pullback, our view on the asset class hasn’t changed. The realisation of some of the catalysts will take longer than the most bullish expectations. But from our perspective, this isn’t wholly unexpected.

When we think about the catalysts, the domestic capex renaissance story remains a key multi-year tailwind for small caps. The structural elements of reshoring building, the domestic manufacturing footprint and revitalising critical infrastructure remains in place. It’s clear the administration wants to incentivise even more spending on the US manufacturing base.

Another tailwind that’s unchanged is M&A investment. Banking M&A pipelines are as full as they’ve been in years. Corporate executives want to do deals. They want to grow their businesses, and private equity has to do deals to keep their business models intact. So, M&A’s coming. We expect a robust multi-year cycle, which is beneficial to small caps.

On the Fed policy front, despite the tariff noise and the hot CPI print, the market still anticipates a rate cut or two this year. We think that’s a reasonable expectation and is more than enough to engender a positive backdrop for small-cap companies.

An important differentiator now versus a year ago is the availability of financing, which is important for small caps. We do think the pace and volatility of policy announcements has introduced an element of near-term uncertainty for corporate execs and consumers. Corporations and execs clearly want to have visibility into the policy end-game before making major decisions, but it’s important to note that it’s only February.

In the end, deregulation is coming. Pro-growth, domestic policies are coming, and it’s likely we have a more friendly tax policy on the way. Those tailwinds are still going to come, and, on the earnings front, we still see an acceleration in earnings growth for small-cap stocks and a deceleration for the largest stocks in the US, albeit from very high levels.

This broadening should unlock some of the significant gap in valuation between large caps and small caps. Positive earnings revisions for small caps have outpaced large this reporting season, so good news on that front. And consensus estimates still have small-cap earnings growth exceeding large- cap earnings growth in late 2025.

There’s clearly always risks. We consider the risk of re-emerging inflation that causes the Fed to reverse course and raise rates. We also consider the risk of policy actions or sentiment causing degradation in economic activity and earnings growth, but we just don’t see it as our base case. In general, the US consumer and the US economy are starting from a very healthy position.

So, we need to be watchful of the policy and macro-related risks. We’re not of the view that it’s changes the attractive fundamental backdrop for small caps and for us as fundamental active managers, the short-term noise and volatility always presents opportunity.

DM: If we think about some of the other factors behind what has been a somewhat disappointing performance, we think about the DeepSeek announcement, questions about the outlook for artificial intelligence, AI spending and how sustainable that is. Has that become a headwind for small-cap technology stocks?

GD: The consternation about artificial intelligence capex has not impacted our ability to find those idiosyncratic, durable growth stocks. The first point would be that small-cap technology companies have a much larger presence in those AI enablers. These are the companies that’ll benefit from proliferation of AI use cases. So as innovation continues in the AI space, costs will come down and usage will increase, which will benefit our small-cap AI enablers.

It’s an imperative for companies to digitise their operations with software solutions that help them fulfil orders correctly, manage their ops within the warehouse, and deliver goods on time. We see this as a market that will grow at a mid-teens annual growth rate through 2028, and the companies that are serving this area have attractive financial characteristics: strong top-line growth, double digits, solid profitability with margin expansion, free cash flow generation, and clean balance sheets. The valuations across application software have broadly normalised since Covid. So, we’re finding good opportunities there.

Taking a step back, tech spending’s not slowing. The leading IT consultant Gartner has released recent data on their expectation for spending growth in 2025. And it’s accelerating and importantly, it’s also broadening. Last year, a lot of that growth was concentrated in the datacentre space. We’re seeing that growth broaden to hardware, software, and IT services this year. So, we really haven’t seen a shortage of attractive ideas in the tech space in small cap.

DM: Aside from the AI related opportunities, are there other areas that you see as particularly compelling right now?

GD: One is healthcare. It’s an area that’s ripe for stock picking and outperformance. It’s a group that’s underperformed the broader market materially over the last couple of years and now trades relatively cheaply. Despite that negative rerating, [the] fundamentals remain strong within the medical technology space. Procedure volumes remain quite robust, particularly for the innovative share gaining med tech companies we invest in. Within the biotech and pharmaceutical space, innovation hasn’t stopped. These companies are still developing novel drugs to address large unmet clinical needs.

The kicker for this group is M&A. We see an uptick broadly. It’ll be particularly acute and beneficial in small-cap healthcare. Large-cap pharmaceutical companies have a ton of cash and are facing an impending patent cliff with close to $170 billion in 2024 sales going off patent. By the end of the decade, those revenues have to be replaced, and we believe much of it will be through acquisitions of leading small-cap biopharma companies.

Another area we still really like are those durable companies that are levered to the multi-year theme of domestic cap spend. We have some infrastructure plays levered to the delivery of liquid natural gas; we have transportation stocks; we have companies leveraged to domestic construction.

There’s really no shortage of interesting opportunities. As fundamental active investors, the inefficiency and volatility within small cap consistently presents opportunity for us to add value.

Daniel Morris: Thank you, Geoff. If I could summarise some of the key points you made. Number one would be you see a quite positive medium-term outlook, expectations for increased capex in the US and, fundamentally, a pro-US growth administration. You talked about opportunities related to AI, but not only healthcare and many other sectors where you do see interesting opportunities. Well, Geoff, thank you very much for joining me.

GD: Thank you, Daniel. Happy to be here.

DM: That’s it for this week’s episode of Talking Heads. If you would like more information, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights @ viewpoint.bnpparibas.com. Viewpoint brings commentary and analysis in a variety of formats from investment outlooks to asset allocation videos and podcasts to help investors make better informed decisions. You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Daniel Morris, and Geoff Dailey, Head of US Equities. Please do join me next week. Until then, take care.