Time was, small caps were the way to go if you believed in Trump’s “America first” mantra.
The assumption, generally speaking, was that by virtue of being U.S.-centric, small caps would be less exposed to the global trade war the administration was hell-bent on instigating. Specifically, the argument boiled down to the idea that less international revenue exposure should equal outperformance.
Not everyone was buying that. Barclays’ Maneesh Deshpande, for instance, said the following back in July just days after the first round of 301 investigation-related tariffs took effect:
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.
The bottom line is that the EBITDA impact is actually larger for small caps than large caps under an all-out trade war scenario.
Fast forward to Tuesday and amid the broad-based risk-off sentiment that swept across global markets, the Russell 2000 erased the entirety of this year’s gains.
The index is in a correction, down nearly 13% from the halcyon days of … well … the halcyon days of two months ago. For the fifth time since the election, the MAGA euphoria inherent in small caps’ relative performance has completely evaporated.
Part of this is likely due to balance sheet concerns as the cycle ages.
“Small caps have thrived on cheap access to capital, where the leverage ratio for nonFinancials (based on Net Debt/EBITDA) of 3.5x is near all-time highs, vs. large caps’ ratio of 1.9x which is in-line with history”, BofAML warned back in August, adding that “excluding Tech, small caps’ leverage ratio is a whopping 3.8x (12% below historical peak), vs. 2.6x for large caps (19% below historical peak).”
As far as U.S. small caps versus global equities, note that the Russell ETF is on pace to log its worst monthly performance versus ACWI since May 2017.