Hopes for US small-capitalisation shares were high after last November’s re-election of Donald Trump. Investors looked for a repeat of the two years after his first election when US equities outperformed the rest of the world, and the small-cap Russell 2000 index outpaced the S&P 500. Daniel Morris and Geoff Dailey discuss what happened next.
That optimism was initially disappointed as US equities lagged non-US markets in 2024 and early 2025, but since April’s shock ‘Liberation Day’ tariff announcement, the trend has reversed (see Exhibit 1).
We believe current conditions support a period of sustained outperformance by US small-cap equities, relative to the non-tech parts of the US market and Europe.
Even during the first Trump administration, the Russell 2000 index did not best the tech-heavy NASDAQ 100. The US technology sector is uniquely well placed to grow profits, and we doubt any major index can outperform it over the medium term. But that does not lessen the appeal of US small-cap stocks.
Any investor is likely to have a limit on how much they are willing or able to allocate to the US technology sector, either via the NASDAQ 100 or the broader S&P 500 (where the tech sector accounts for nearly 50% of the market value).
Thus, US small caps can be appealing as a way to increase exposure to the superior earnings potential of the US market exactly without increasing exposure to the technology sector.
Impact of tariffs on small caps
Both the large cap, non-tech parts of the US market (proxied by the Russell 1000 Value index) and large-cap European equities are more disadvantaged by US import tariffs than US small-cap stocks.
The lack of retaliation by US trading partners to date means that US exporters do generally not face higher tariffs abroad than before ‘Liberation Day’, putting European equities (which do face tariffs) at a relative handicap.
European exporters are having to cope not only with US tariffs, but a stronger currency. Recall that exports account for 33% of GDP for the eurozone versus 7% for the US, so a decline in exports has a significant impact on profits.
European producers face a further challenge as competition from China increases. As Chinese exports to the US have fallen, China is redirecting more of its output to Europe.
US retailers face higher tariffs on imported goods (think Walmart) or on inputs to their production process (think Ford). That puts larger companies at a disadvantage vis-à-vis smaller US firms, who likely source inputs more at home.
The investment case for US small cap stocks
Originally, after the US election, there was a case to be made for superior returns from US small cap equities relative to large caps (and US equities relative to the rest of the world).
This was based on the assumption that US growth would accelerate thanks to the new administration’s planned fiscal stimulus and tax cuts, more lending by banks, and deregulation – faster permitting of projects, less red tape and fewer hurdles to mergers and acquisitions (M&A).
Tariffs had always been part of the equation. They were viewed as positive for US equities as they would encourage investment in local manufacturing and reorient demand towards domestically produced goods.
The market’s negative reaction after ‘Liberation Day’ was because the tariffs were much higher than expected and the concern was that retaliation could lead to a global recession. Those worries have turned out to be exaggerated.
We believe most components of that original investment case are intact. The new US administration is expected to be more supportive of M&A.
PWC estimates that deal values for the first half of 2025 will have been the highest in three years, and now that the benchmark fed funds rate has begun to fall, activity should increase further. Small caps tend to outperform large caps once the US Federal Reserve begins cutting interest rates as they benefit more from lower financing costs.
Despite the setback from higher tariffs, US economic growth is still likely to be stronger than that in most of the rest of the world in 2026. Consumer demand has been robust and the greater customer concentration in the US of small-cap companies should be a benefit to the segment.
Earnings growth and reasonable valuations
If equities returns are always about ‘earnings, earnings, earnings’, US small caps should see support in the months ahead. Expectations for small-cap earnings growth over the next year are more positive than for either the Russell 1000 Value or for Europe.
Importantly, this earnings growth is coming with reasonable market valuations. Few markets are cheap in absolute terms these days, but the current forward price-earnings (P/E) ratio of 25x is closer to average valuations than 17x for the Russell 1000 Value or 15x for Europe.
Relative to history over the last 10 years, the 25x Russell 2000 P/E translates into a z-score of 0.8, whereas the z-score for the Russell value index is 1.4 and 0.2 for Europe (see Exhibit 3).
US small-cap stocks may be having their moment. The outlook for earnings is good, supported by a robust US economy, fiscal stimulus, monetary policy easing, and pro-growth government policies. Valuations are currently somewhat high, but if earnings rise at the rate analysts expect, multiples should moderate over time.
Finally, US small-cap stocks offer investors a way to tap into the historically higher earnings appreciation of the US market without increasing their exposure to the mega-cap tech sector.
