US small-cap equities – Time to shine?

In this report we consider whether the recent move into US smaller-cap stocks is sustainable. The valuations of these companies are certainly more attractive than those of larger-cap businesses, but valuation alone is not a catalyst for a shift in stock market leadership. However, we see potential for a re-rating of small-cap stocks if there is a reduction in US interest rates. For investors interested in gaining exposure to US small-cap companies, we highlight two specific North American smaller company funds and four global smaller company funds with meaningful US exposure. We also highlight examples of listed private equity firms which could, to some degree, be supported by lower US interest rates and higher US small-cap share prices.

Will US SMID-cap momentum continue?

US smaller-cap stocks have been out of favour with investors, with mega-cap technology stocks, in particular, making the headlines. In 2023 the share prices of the so-called ‘magnificent seven’ – Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA and Tesla – rose on average by more than 100%. The positive trend has largely continued into 2024, supported by further gains in artificial intelligence-related stocks and the increasing appeal of passive funds, whose inflows fuel further gains in the largest stocks in a rising market.

While the US 1000 index is still ahead of the US 2000 index in the year to date, in the five trading days between 9 July and 16 July, there was a significant c 9.5pp performance differential between the two indices in favour of smaller-cap stocks, and this momentum has continued. The catalyst for the change in market leadership was weaker-than-expected US inflation data, prompting an increase in the probability of a September 2024 interest rate cut as measured by the CME FedWatch tool. A successful bid by Donald Trump for a second term in office could also be considered a positive for small-cap stocks given his ‘pro-business’ stance and the potential for lower taxes and decreased regulation. However, his lead in the polls has narrowed following President Joe Biden stepping down, paving the way for much younger Vice-President Kamala Harris to fight for the Democrats to remain in the White House.