On Sunday evening, Morgan Stanley cut U.S. small caps from overweight to equal-weight, effectively calling into question the sustainability of the Russell 2000’s outperformance.
Small caps have recently been viewed as something of a natural hedge against the trade war and alongside tech, have helped shelter U.S. equity investors from the proverbial squall amid the ongoing trade tensions.
“US small caps have been the safe haven of choice over the S&P 500 as investors view them as less vulnerable to rising trade tensions,” Morgan Stanley’s Michael Wilson wrote, adding that while the narrative “makes sense intuitively,” the bank is “skeptical that US-centric small cap companies would be immune to a major escalation in trade tensions, which would ultimately be a significant drag on the US economy, too.”
That’s the kind of common sense, 30,000 foot approach and as I wrote over the weekend, “the investment case seems to be predicated almost entirely on assumed insulation from the trade conflict, which means you could get underperformance if trade tensions fade, and if they don’t (i.e., if trade frictions get worse), you could discover that whatever safety goes along with being in U.S. small caps was already priced in.”
For their part, SocGen has variously suggested that U.S. small caps are likely to suffer going forward for a variety of fundamental reasons (see the post linked here at the outset for more on that).
Well now it’s Barclays’ turn.
In a note dated Monday, the bank’s Maneesh Deshpande throws more cold water on the small cap rally.
“One of primary reasons for small cap outperformance over large caps has been the belief that because they have less international revenue exposure than large caps, they are less exposed to a potential trade war,” Deshpande writes, stating the obvious and referencing the following visual:
But that’s not the whole story. Here’s Barclays digging a little deeper:
What really matters for estimating the impact of tariffs are the actual imports and exports and margins. Figure 13 shows the import/export values for small caps and large caps, as well as the impact on EBITDA in an all-out trade war scenario (10% tariff on all imports by U.S., 10% retaliatory tariffs by trade partners on exports). Note that these numbers are across all trading partners and not just China. We switch to EBITDA rather than net income since a significant fraction of Russell 2000 companies already have negative earnings.
Without subjecting you to the specifics on the modeling there (suffice to say the marked worsening on exports in Model B versus Model A is down to how exports are measured), the bottom line is that the EBITDA impact is actually larger for small caps than large caps under an all-out trade war for the following reasons:
While small caps have lower international sales as a % of total sales than large caps (20% vs 30%), their export/sales is only slightly lower (5.5% vs 6.6%).
Small caps have significantly weaker EBITDA margins, resulting in a higher % of earnings loss for the same increase in costs relative to sales.
While small caps have Export/Sales ratio relative to large caps, their Imports/Sales ratio is much higher. Thus the impact of import tariffs (imposed by the U.S. government) is likely to be much higher than large caps.
Needless to say, if Barclays is right and small caps are actually more exposed to a full-blown trade conflict than large caps, their outperformance leaves the risk skewed asymmetrically to the downside, and the bank says as much in the last paragraph of their analysis.
Whether you quibble with the methodology is largely irrelevant here. The point, rather, is that folks are starting to look more closely at whether it actually makes sense to pile indiscriminately into small caps based on what amounts to surface level analysis about how they generate their revenue.
The devil, as ever, is in the details.
Soooo, who’s up for shorting the RUT? All raise your hands please.