Small Caps Get Hit Again. Be Patient, Headwinds Are Falling.

Small-cap stocks have been through a rough patch in recent years, lagging behind their large-cap counterparts. However, investors should not lose hope, as the tide may be turning in favor of small caps. This article explores the recent performance of small caps, the factors contributing to their underperformance, and the potential for a reversal of fortune.

In 2022 and 2023, the phase of fast and forceful monetary policy tightening was a headwind for interest-rate sensitive small caps, which carry more floating-rate debt than their large-cap counterparts. This led to a significant underperformance of small caps compared to large caps. However, the macroeconomic backdrop has turned more favorable in recent months, with decelerating inflation, steady economic growth data, and the onset of interest rate easing cycles globally. This shift has begun to relieve pressure on small-cap balance sheets, leading to an outperformance of small caps in the third quarter of 2024. The MSCI World Small Cap Index delivered 9.3% in 3Q 2024, outpacing the MSCI World Index which delivered 6.1%.1

The underperformance of non-US small caps can be attributed to the US dollar's strength and weaker economic growth in Europe. The US dollar's appreciation makes exports from non-US countries less competitive, negatively impacting the earnings of small-cap companies in these regions. Additionally, slower economic growth in Europe, particularly in recent months, has dampened the performance of European small caps. However, the author believes that small caps across regions will benefit from rate-cutting cycles and growth-supportive central bank policies, which should favor margins in the near term and reduce medium-term downside risks from interest expenses on floating-rate debt.

The outperformance of US small caps during the summer of 2024 was a significant factor in the reversal of fortune for the small caps segment. This period saw a 9.3% climb in the Russell 2000 Index, outpacing the S&P 500 Index's 5.9% growth. This performance was driven by a supportive macroeconomic backdrop, including decelerating inflation, steady economic growth, and the onset of interest rate cycles globally. The summer rally was further boosted by the fact that US small caps have historically outperformed following the end of a rate cycle. This trend, combined with the current low valuations relative to large caps, suggests that small caps may continue to outperform, making them an attractive investment opportunity for patient investors.

Small caps have historically lagged large caps in earnings growth, but recent trends suggest a reversal of fortune. In 2024, small caps outperformed large caps, with the MSCI World Small Cap Index delivering 9.3% in 3Q 2024 compared to the MSCI World Index's 6.1%. This outperformance was driven by a supportive macroeconomic backdrop, including decelerating inflation and interest rate easing cycles. As interest rates fall, small caps, which carry more floating-rate debt, benefit from reduced interest expenses, enabling them to fund long-term growth more affordably. Despite a summer surge in investor interest, small caps remain undervalued relative to large caps, with the global universe of small caps trading at a -32% discount to its historical average. This valuation disconnect, combined with solid earnings prospects and increased return dispersion, strengthens the case for adding small caps as a diversifier and additional source of returns in a broader portfolio.

In conclusion, small-cap stocks have faced headwinds in recent years, but the tide may be turning in their favor. A supportive macroeconomic backdrop, low valuations relative to large caps, and solid earnings prospects suggest that small caps could be poised for further upside in 2025. Investors should remain patient and consider adding small caps to their portfolios as a diversifier and additional source of returns.