Small caps poised for a comeback

The US Manufacturing Purchasing Managers Index (PMI) is one of the many gauges of economic health. As shown in the chart, the relative performance of US small caps (S&P 600) versus large caps (S&P 500) generally tracks movements in the PMI. This underscores small caps’ heightened sensitivity to economic shifts. While the PMI has stabilized in recent years, small caps have lagged—potentially setting the stage for a reversal if economic momentum picks up.

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Small cap equities: forgotten but not gone

Over the past year, small cap equities have remained one of the most overlooked corners of the market. Performance has lagged, and earnings have yet to return to their post-COVID highs—marking a notable divergence from their large cap counterparts.

This decoupling is particularly striking in the US, where small cap earnings have not followed the same upward trajectory as large caps. In most other developed markets, small and large cap earnings have generally moved in tandem. The US stands out as an exception, underscoring a unique dynamic in the domestic equity landscape.

One way to interpret this divergence is through the lens of economic structure versus economic cycle. Large cap earnings growth often reflects some of the structural growth of the US economy—driven by global exposure, scale advantages, and access to capital. Small caps, on the other hand, are more sensitive to the local business cycle. Their performance tends to mirror shifts in domestic demand, labor costs, and credit conditions. Over the past few years, while overall US economic growth has remained positive, it has been gradually decelerating. Small cap earnings have mirrored this slowdown, highlighting their cyclical nature.

Several macroeconomic headwinds have compounded the pressure on small caps. Higher interest rates have been particularly challenging, given small companies’ greater reliance on debt financing, and the broader economic drag from reduced consumer spending as borrowing becomes more expensive. Elevated borrowing costs have squeezed margins and dampened investment. Additionally, the ongoing tariff environment has introduced further uncertainty. With generally lower margins than large caps, small companies are more vulnerable to rising input costs and supply chain disruptions.

Yet, despite these challenges, there are reasons for cautious optimism. As highlighted in a recent note to clients, there are a number of emerging tailwinds that are supportive of all US equities, but some particularly for small caps:

1. Monetary Policy Shift: The Federal Reserve has begun easing interest rates, which could alleviate financing pressures and stimulate investment.
2. Pro-Business Legislation: Washington has introduced market-friendly policies, including expanded small business deductions, 100% expensing for new investments, and tax relief on tips and overtime—all of which could boost profitability.
3. Regulatory Easing: Continued deregulation may reduce compliance costs and spur M&A activity, providing growth opportunities for nimble small cap players.
4. AI-Driven Productivity: The rise of artificial intelligence offers potential productivity gains, even for smaller firms, through automation and operational efficiency.

Some of these factors are already reflected in forward earnings estimates. Starting in Q4 and extending into next year, expectations for small cap earnings are beginning to catch up to those of large caps. This shift suggests that analysts are starting to price in a more favorable environment for smaller companies.

However, the key question remains: are these higher earnings already priced into valuations?

Small cap equities continue to trade below their 10-year average, indicating a lack of conviction and sentiment in the asset class. This stands in contrast to large caps, where valuations have remained elevated, supported by strong earnings and investor enthusiasm.

While our broader preference for US equities remains intact, being underweight small caps has generally been a rewarding stance over the past few years. But as we look ahead, investors shouldn’t forget about small caps, which has begun to show signs of improvement in recent months. With improving fundamentals, supportive policy shifts, and attractive valuations, small caps could be poised for a comeback.