Eyes on US small caps after post-tariff turmoil

Hopes for US small cap stocks were high following the re-election of Donald Trump last November. Investors looked for a repeat of the two years following his first election, when US equities outperformed the rest of the world, and the Russell 2000 index of small cap stocks outperformed the S&P 500.

That optimism was initially disappointed as US equities lagged non-US markets in 2024 and early 2025, but since the shock ‘liberation day’ announcement in April, the trend has reversed.

Current conditions support a period of sustained outperformance, relative to the non-tech parts of the US market and Europe. Even during the first Trump administration, the Russell 2000 index did not better the Nasdaq 100. The US technology sector is uniquely well placed to increase profits and we doubt any major index will be able to 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 S&P 500 — where the sector accounts for nearly 50 per cent of market value. US small caps are appealing as a way to increase exposure to the superior earnings potential of the US market, but without increasing exposure to the technology sector.

Impact of tariffs

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 means that US exporters are generally not facing higher tariffs than before liberation day, putting European equities at a relative disadvantage.  

European exporters are also having to cope not only with US tariffs but a stronger currency. Recall that exports account for 33 per cent of GDP for the eurozone versus 7 per cent for the US, so a decline in exports has a big impact on profits. European producers face an additional 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 are nonetheless facing 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, whose inputs are likely sourced more domestically.

Exaggerated worries

The original investment case after the US election for superior returns from US small cap equities relative to large — and US equities relative to the rest of the world — was that US growth would accelerate thanks to the new White House administration’s planned fiscal stimulus, tax cuts and deregulation. This would apparently lead to faster permitting of projects, less red tape, greater lending by banks and fewer hurdles to mergers and acquisitions (M&A).

Tariffs were always part of the equation, and they were viewed as positive for US equities as they would encourage investment in US manufacturing and reorient demand towards domestically produced goods.

The market’s negative reaction following liberation day was because the tariffs were much higher than expected and the fear was that retaliation could lead to global recession. Those worries have turned out to be exaggerated.

Most of the components of that original investment case remain 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 be the highest in three years, and now that the fed funds rate has begun to fall, activity should increase further.

Small caps tend to outperform large caps once the Fed 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 most of the rest of the world in 2026. US consumer demand remains robust and the greater customer concentration in the US of small cap companies should be a benefit.

Great expectations

If equities returns ultimately are always about ‘earnings, earnings, earnings’, then US small cap stocks should see some support in the months ahead. Expectations for small cap earnings growth over the next year are more positive than for either Russell 1000 Value or for Europe.

Importantly, this earnings growth is coming with reasonable 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 the 17x for Russell 1000 Value or the 15x for Europe. Relative to history over the past 10 years, the 25x Russell 2000 P/E translates into a z-score of 0.8, whereas the z-score for the value index is 1.4 and 0.2 for Europe.

US small cap stocks may be having their moment. The outlook for earnings is good, supported by a strong US economy, fiscal stimulus, monetary policy easing and pro-growth government policies. Valuations are 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.

Daniel Morris, chief market strategist and Geoff Dailey, head of US equities and senior portfolio manager, BNP Paribas Asset Management