Since 2022, we have predicted that small cap stocks, especially those representing innovative businesses with pricing power, would do well in an environment of disinflation and positive economic growth.
Since the end of 2022, the U.S. Russell 2000 Index of small-cap stocks has risen 36 per cent, the U.S. S&P SmallCap 600 index is up 31 per cent, and the S&P/ASX Small Ordinaries index has risen 12 per cent.
Interestingly, most of the gains in the Russell 2000 Index (23 per cent) have been recorded since April this year, and the S&P SmallCap 600 is up 21 per cent over the same period. The bulk of the gains over the last two years have occurred in the last two or three quarters.
Given the disinflation/ positive gross domestic product (GDP) picture was no different before April and after April, we can put the acceleration down to something else. That something else may just be bets that a Trump election victory would be positive.
If so, why have U.S. small caps done well amid a Trump victory?
Answering that question may offer some insights into what happens next (for what it’s worth, I believe the small caps rally, which commenced in 2022, should continue into 2025, and we should reappraise the situation towards the end of 2025.
Domestic focus: Small-cap companies often derive a significant portion of their revenue from domestic operations. The last Trump administration emphasised policies that stimulated domestic economic growth, such as infrastructure spending and tax reforms, benefiting these companies.
Tax cuts and jobs act of 2017: Trump last reduced the corporate tax rate from 35 per cent to 21 per cent. Small cap companies generally paid higher effective tax rates compared to larger, multinational corporations. The reduction in taxes disproportionately benefited smaller companies, improving their profitability.
Deregulation efforts: The last Trump administration pursued deregulation across various sectors, reducing compliance costs and operational burdens. Due to these policy changes, small businesses, which have fewer resources to manage regulatory complexities, found it easier to expand and invest.
Trade policies: The focus on renegotiating trade agreements and implementing tariffs affected multinational corporations more than domestically oriented small cap companies. Large-cap companies with extensive international operations faced uncertainties and potential losses, whereas small caps were relatively insulated.
Economic growth and consumer confidence: The period saw steady economic growth and high consumer confidence levels. Increased consumer spending boosted revenues for small businesses that rely heavily on domestic markets.
Stronger U.S. dollar: A stronger dollar can negatively impact multinational companies by making exports more expensive and reducing the value of overseas earnings. With limited international exposure, small-cap companies were less affected by currency fluctuations.
Infrastructure initiatives: Proposed investments in infrastructure projects promised potential contracts and growth opportunities for smaller companies in construction, manufacturing, and related industries.
Together, the first time around, these factors created an environment where small-cap stocks could outperform their larger counterparts. Under a second Trump term, many investors believe the same is in store, which is why the Russell 2000 Index was up five per cent the day after Trump’s win. Of course, it’s important to remember honeymoons never last and stock performance is influenced by a variety of factors, including global market conditions, geopolitical conflict, investor sentiment, and, most importantly, profit growth.
For now, and until late 2025 (and excepting a war with China), I believe small caps will do well.