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The US economy emerged from the pandemic with greater strength than most other economies around the globe. That rebound was fueled, in part, by the fiscal stimulus the Biden Administration promoted with two major pieces of legislation – the CHIPS (Creating Helpful Incentives to Produce Semiconductors) and Science Act and the Inflation Reduction Act (IRA) – but the US consumer has demonstrated, once again, a propensity to drive the economy. With a strong labor market and likely policies from the next Trump administration that support domestic growth, indications suggest investing in the US economy could remain beneficial. However, US equities are expensive, and investors could assume the market has already priced in this growth. The latter point may be true of large-cap US equities, but not most other US companies.
We remain confident that US exceptionalism will continue to reign in 2025, and, for investors, we believe US small- and mid-cap stocks could offer a relatively inexpensive way to participate in the robust US economy.
An inexpensive way to gain exposure to US economic strength
Many US large-cap companies compete on the global stage, and their revenues are therefore more dependent on the global economy. Small- and mid-cap companies are much more likely to have customer bases that are either exclusively or predominantly in the United States. For that reason, small- and mid-cap stocks can provide investors with more direct exposure to the US economy. Given how expensive large caps are today, small- and mid-cap stocks also provide a less costly way to gain that exposure. As Figure 1 shows, the price differential between small and large caps still demonstrates that gaining or increasing exposure to the strong US economy does not have to come with a hefty price tag.
Figure 1: Small and mid caps remain cheap relative to large caps
Source: FactSet data as August 31, 2024. Source: Schroders. Past performance is not a guide to future performance and may not be repeated.
Key trends could benefit small- and mid-cap stocks
It is true that small- and mid-cap valuations have been at a discount to large caps for several years. So what is changing as we head into 2025? Beyond the ongoing strength of the US economy and the pricing considerations, a number of key trends could also work together to create a highly favorable environment for small- and mid-cap stocks.
- The recovery in M&A activity and IPOs is likely to continue in 2025.
In 2022 and 2023, concerns about a recession, high company valuations and soaring inflation significantly slowed mergers and acquisitions (M&A) activity and initial public offerings (IPOs). Globally, 2023 was the second-worst year for M&As in a decade.1 A strong comeback, fostered by less expensive valuations, began in 2024. M&A activity in North America through the first three quarters of 2024, for example, almost surpassed the deal value for all of 2023, and it is on pace to stage a 30% rebound for the year.2 Stabilizing interest rates and improving economic conditions could fuel an even stronger rebound for M&As and IPOs in 2025.
The pickup in M&A activity and IPOs benefits small-cap stocks in multiple ways. Attractive small caps often become acquisition targets, and high-quality companies garnering headlines as they go public increases interest in the small-cap space. Overall, the pick-up in animal spirits demonstrated by greater M&A activity and IPOs delivers the optimism that increases risk appetites and the confidence investors may need to pursue the potentially stronger growth small caps can deliver.
While a rise in IPOs increases the number of small-cap companies, active managers still must be selective. With the newly public companies, in particular, careful consideration is required by those managers who participate in IPOs. While IPOs are renowned for historically delivering initial outperformance, selectivity is still needed to find the companies that can deliver on that promise.
History demonstrates that periods of increasing M&A activity have delivered exceptionally strong performance for stocks across the capitalization spectrum. (See Figure 2.) The gains registered by small caps during these periods have been on pace with the returns generated by large caps, and mid caps have outpaced both.
Figure 2: Periods of rising M&A activity have historically delivered strong equity returns
Source: Schroders. Past performance is not a guide to future performance and may not be repeated.
2. Inflation is now in a range that has been particularly favorable for small caps.
While small caps have historically outperformed their large-cap brethren in periods when annual inflation has exceeded 1%, the higher interest rates that come when central banks try to reduce high inflation can be challenging for small companies. Much of their debt is financed with shorter-term and floating-rate instruments. As a result, financing became much more expensive for the small caps when the Fed began hiking rates in early 2022.
With the declining rate environment that began in the fall of 2024 and is expected to continue through 2025, conditions are now likely to be much more favorable. The small-cap companies’ debt will become less expensive. Further, the macroeconomic conditions that enabled the Fed to reduce rates – slowing inflation and below-trend growth – have historically been a climate in which small caps can outperform other asset classes, including large-cap stocks, bonds and commodities. With a century of history as evidence, the range that inflation seems to have now settled into – 1% to 3% – is one that has historically enabled small caps to deliver exceptional returns. (See Figure 3.)
Figure 3: Average small-cap returns have been particularly strong when inflation has been 1%-3%
Source: Schroders, Data to end of 2023. Based on rolling 12-month periods. Past performance is not a guide to future performance and may not be repeated.
3. Wall Street is forecasting a bigger rebound in small-cap earnings, starting in Q4 2024 and through much of 2025.
The developments that made 2023 such a difficult year for small caps – rate hikes and the ripple effects of the collapse of Silicon Valley Bank – may now be well in the rearview mirror. The favorable conditions noted here may explain why a consensus of Wall Street analysts believe that in the fourth quarter of 2024 and for every quarter of 2025 except the first, the rebound in earnings for small caps will exceed the bounce experienced by large caps. (See Figure 4.)
Figure 4: Wall Street forecasts a bigger increase in earnings for small caps
Year-over-year, earnings-per-share (EPS) growth estimates for S&P SmallCap 600 Index versus S&P 500 Index (Growth FactSet Research until Q4 2023, Custom EPS Q12024 forward)
Source: FactSet, Schroders. There is no guarantee the forecast will be realized.
4. While the megacap tech stocks have been dominating the AI headlines, many small-cap companies will help propel the AI revolution.
Artificial intelligence (AI) needs much more than the sophisticated chips provided by companies like NVIDIA. For example, thermal management solutions are critical to manage the extreme heat generated by those AI chips. Optical communications will provide the high bandwidth, low latency and large data capabilities that are necessary to support the massive data-processing demands of AI applications. Data storage and management, software development, and cybersecurity are all equally critical. Small-cap companies are often key, and even leading, players in these industries that will both shape and benefit from the growth that the AI revolution generates.
5. The continued growth of the service sector helps small and mid caps, which operate predominately in this space.
While US manufacturing has experienced a rebirth in recent years, helped by federal legislation, the US is primarily a service-oriented economy. In the second-quarter of 2024, private services-producing industries represented 72% of the US gross domestic product (GDP).3 The decades-long shift that started to take a dramatic turn in 1977 – when services still accounted for only 54.7% of US GDP – continues to reshape the US economy.4 While large-cap companies dominate the manufacturing and consumer goods sectors, small-cap companies are often key players in service sectors, so they are among the beneficiaries of this shift.
6. Reshoring enables more small- and mid-cap companies to step in as reliable suppliers.
COVID-19 and the lockdowns at Chinese manufacturers and other suppliers led many companies to reconsider their supply chains. The move to onshoring benefits many small US companies that are replacing global competitors as the suppliers to large US firms.
7. Small- and mid-cap companies will be prime beneficiaries of the increases in CAPEX.
Capital expenditures have been increasing for a number of reasons, including the shift to automation, as companies look to lower costs and stay competitive, and the financial support the government is providing key sectors like the semiconductor industry and renewable energy sector through the CHIPS Act and the Inflation Reduction Act. Historically, CAPEX has always been highly correlated with small caps’ revenue, and the increases portend growth.
A reminder that the market does rotate – eventually
Large caps have been on such an extended run since the end of the Global Financial Crisis that it can be easy to forget that the market does rotate. Small caps registered their own run of outperformance from 2000 to 2006, a period that demonstrated their ability to deliver exceptional returns through changing GDP conditions and federal funds regimes, as Figure 5 illustrates. It is a worthwhile reminder that an extended run of outperformance has never represented a permanent change of conditions.
Figure 5: Small caps have demonstrated their ability to outperform in a variety of growth and rate regimes
Source: Schroders. Past performance is not a guide to future performance and may not be repeated.
Conclusion: Favorable conditions for small caps amid signs that the market is already broadening
The large versus small caps debate that has played out recently has been complicated by the fact that it was really just the “Magnificent Seven”5 stocks propelling the market to greater heights in the aftermath of the pandemic. Signs that the market was broadening beyond the “Mag 7” appeared in 2024. That broadening benefits not only the other constituents of the S&P 500 Index but also small- and mid-cap stocks. Without the benefits of a crystal ball that might reveal when the inevitable market rotation from large- to small-cap stocks might begin, there are still plenty of signs that suggest small- and mid-cap stocks warrant a reasonable allocation in investors’ portfolios in 2025 and beyond.
References:
- Source: “2023 Annual Global M&A Report,” PitchBook, 1/23/24
- Source: “Q3 2024 Global M&A Report," PitchBook, 10/23/24
- Source: “Value added by Industry: Private Services-Producing Industries as a Percentage of GDP,” Federal Reserve Bank of St. Louis, reporting data from the US Bureau of Economic Analysis, 9/26/24
- Source: “Gross Domestic Product by Industry for 1947-1986: New Estimates Based on the North American Industry Classification System,” by Yuskavage, Robert. E., and Fahim-Nader, Mahnaz, Bureau of Economic Analysis, December 2005
- The Magnificent Seven stocks are Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla.
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