Small-cap stocks would likely be the biggest outperformers in a “Goldilocks” scenario of robust US growth, falling US inflation, and preemptive US rate cuts. (UBS)

Small caps would benefit even more in the event of a “Goldilocks” outcome of strong US growth, falling inflation, and swifter-than-expected rate reductions.

Small-cap stocks have lagged in recent years.

  • The Russell 2000 index, an index of US small-cap companies, is down 3.1% so far in 2024, as of 5 February, versus a 4% gain for the S&P 500 large-cap index.
  • Over the past five years, US small-caps have advanced around 26%, lagging a roughly 83% gain in the S&P 500.
  • In 2023, large-cap tech stocks led the way, with the FANG+ index gaining 96% compared to a return of 16.9% for the Russell 2000.

But the outlook for smaller companies looks brighter for 2024.

  • Valuations are attractive for small-caps after a long period of underperformance, both in the US and Eurozone.
  • Small-caps are more reliant on floating-rate loans and so stand to gain more from rate reductions from the Fed and ECB.
  • The earnings per share growth for small-cap companies looks set to outpace the broader index this year in the US

So a modest allocation to this part of the equity market can add value to portfolios, in our view.

  • While small-caps are generally more cyclical, the segment should perform well in our base case of a soft landing for the US economy.
  • In addition, we believe US and European small-caps, along with Swiss mid-caps, would be among the main outperformers in a Goldilocks scenario of robust US growth, falling US inflation, and preemptive US rate cuts.

Did you know?

  • In terms of valuations, the Russell 2000 is trading at a roughly 55% discount to the Russell 1000 versus a 10-year average discount of 32%, while the forward price-to-earnings ratio for the S&P 600 is also lower than its 10-year average. In the Eurozone, the relative valuations of small- and mid-caps are even lower than at the trough during the global financial crisis, suggesting the biggest discount since the tech bubble in the late 1990s and early 2000s.
  • Since nearly half of the debt held by Russell 2000 companies is floating rate, versus around a tenth for large-cap companies, Fed rate cuts can quickly start to reduce interest expenses for small-cap companies.
  • The total value of the Russell 2000 index is just around USD 3tr and accounts for only 6% of the total US equity market capitalization.

Investment view

The long-term advantages of a modest allocation to small-caps are often overlooked, including diversification and a potential boost to returns. In addition, on a tactical basis, small-caps appear well positioned to outperform as central banks cut rates.

Main contributors - Matthew Carter, Vincent Heaney, Christopher Swann

Original report - Can small-caps add value to my portfolio?, 5 February 2024.