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        Surging Tailwinds Support US Small and Mid-Cap Stocks

        US small and mid-cap companies may be key beneficiaries of relentless US exceptionalism, rising small business optimism, and the new US president’s policies aimed at supporting domestic businesses. Meanwhile, more globally oriented large-cap indices may be challenged to a greater extent in the longer run by tariff-related uncertainty, as well as market concentration.

        4 min read
        Krzysztof Janiga, CFA
        Senior Equity ETF Strategist

        Performance Catching Up with Large Caps

        The Russell 2000® and the S&P MidCap 400® Indices have performed broadly in line with S&P 500® since the beginning of 2H 2024. We remain positive about small and mid-cap stocks as valuations, home bias and cyclicality are clear tailwinds in the new regime. Key risks to monitor include inflation, geopolitical challenges, and tariff policies, which could dent investor sentiment.

        US small and mid caps saw significant swings in performance over the course of 2024, reflecting their high beta exposures. July’s rally was the result of inflation abating, which brought forward long-awaited Federal Reserve (Fed) interest rate cuts. August and September brought concerns about US growth, leading to short-lived drawdowns until investors concluded such worries had been exaggerated.

        In November, the Republican electoral sweep sparked a sharp rally, which abated in December as the Fed delivered a hawkish cut. The S&P MidCap 400 and the Russell 2000 indices enjoyed modest gains in the beginning of 2025, reflecting the strength of the US economy, expectations of Trump policies, and a slightly better inflation backdrop.

        Looking at historical patterns, from a macro standpoint, our view is that inflation and the Fed’s level of hawkishness will be key market movers. Declines driven by fears of a recession, slowdown, or labour market weakness should be treated as buying opportunities.

        The Russell 2000 and the S&P MidCap 400 are far less concentrated than large-cap indices. The top 10 constituents represent only 3.8% and 6.7% of their respective market caps. The corresponding figure for the S&P 500 is 37.3%.1 Over the past two years, in the time of the Magnificent 7 tech giants, this diversification brought little benefit.

        Now, however, market concentration may pose a significant risk as new entrants like Chinese startup DeepSeek challenge the AI dominance of expensive mega cap companies. Small and mid-cap indices, thanks to diversified profiles and balanced sector composition, are far less prone to this headwind.

        Figure 1: Index Performance Since Jul 2024

        US Exceptionalism Shows No Signs of Fading

        We constructive about the prospects of the US economy for three reasons:

        1. Upcoming fiscal policies, including lower corporate tax rates
          The fiscal policies of the new Republican administration under Trump should, on a relative basis, benefit the domestic US economy.
        2. US growth chronically underappreciated by economists worldwide
          Consumption has not faded despite relatively tight monetary conditions.
        3. US economic prospects supported by small business optimism
          Inflation is a key risk factor, due to small-cap sensitivity to rates, and tariffs against Canada and Mexico create downside risk for an otherwise balanced inflation backdrop. The key question is whether tariffs against these two countries will be durable. From the fundamental standpoint small caps should be less sensitive to tariffs than large Caps thanks to their more domestic profiles.

        Bottom line, we continue to endorse adding risk through US small and mid-cap exposures, because they are more domestic and cyclical, and would benefit from US economic strength and gradual monetary easing.

        Figure 2: Evolution of Real GDP Growth Estimates

        Small Businesses See Reasons for Optimism

        The latest respected NFIB survey records a sharp improvement in small business optimism. The net percent of owners expecting the economy to improve has risen to its highest peak in 40 years, since Q4 of 1983. The share of business owners believing now is a good time to expand their business, and the proportion expecting higher real sales volumes, rose to levels unseen since the pandemic.2

        Small cap companies are, on average, larger than “small businesses” but the data imply that prospects for the US economy remain bright, especially its domestic part, which is crucial for small and mid-cap companies. The number of IPOs included in the Russell 2000 Index has also risen since Q2 2024. 

        Figure 3: NFIB Small Business Optimism Running High

        Valuations Still Make US Exceptionalism Affordable

        High valuation multiples of US and market concentration, are key considerations holding investors back from weighing in further, whereas US small cap and mid-cap stocks trade at relatively undemanding valuations.

        There are caveats. Companies with negative earnings represent approximately 30% of the Russell 2000 market cap. There is a significant presence of Biotech and Software companies that are yet to breakeven. These companies may often significantly contribute to both upside and downside moves depending on market sentiment, making Russell 2000 a high-risk, high-reward type of exposure.

        Looking at price-to-earnings ratios, using positive earnings, Russell 2000 screens as affordable relative to large caps and to its own history. Given the potential for AI adoption in Health Care and IT, we see an investment case also for these early life-cycle companies in the Russell 2000.

        Investors looking for higher quality exposures could consider the S&P MidCap 400 Index, which only includes companies that have a record of generating positive earnings. The index also maintains attractive valuations relative to the S&P 500 and is expected to deliver similar, low double-digit earnings growth over 2025.3

        Figure 4: Small Cap and Mid Cap Valuations Relatively Attractive

        Three Different Flavours to Choose 

        The Russell 2000 and the S&P MidCap 400 derive 84% and 76%, respectively, of revenues domestically.4 Small cap indices are pro-cyclical from a sector standpoint. They overweight Financials, Industrials and the more traditional part of Consumer Discretionary.

        This is a tailwind, in our view, given the fact that US economy continues to surprise to the upside. There are similarities but each exposure offers a slightly different flavour.

        The Russell 2000 is the most unconstrained tool for accessing US small caps and so it remains high on the risk-reward ladder. Beyond the aforementioned cyclical sectors, there is a significant exposure to Biotech and Software industries, which would benefit from the AI developments supported by the new Trump administration. Revival of Merger and Acquisition (M&A) activity, which is a likely outcome of Trump’s deregulation plans, would add further momentum to these segments.

        The S&P MidCap 400 Index offers more traditional sector composition. Industrials, the largest sector, would benefit from the Infrastructure and Jobs Act, the CHIPS and Science Act, and the Inflation Reduction Act. The latter may be diluted under the Trump administration but these fiscal programs are endorsed by both parties at state level, so reductions may be limited and their impact may be more than offset by the increase in domestic investments into AI and data centers.

        The S&P MidCap 400 Index often brings out the best of the two worlds. Just like small caps, it allows investors to access a domestic cyclical and diversified exposure that trades at relatively undemanding valuation multiples. And it also offers relatively higher quality exposures compared to small caps. This is due to the size of its constituents and the S&P earnings screening upon initial inclusion into the composite index.

        The MSCI USA Small Cap Value Weighted Index perhaps offers the strongest cyclical and value tilts. Financials represent nearly a quarter of the index and there is a significant Technology underweight, so this exposure may benefit the most from three potential types of market rotation: size, value, and cyclical sector rotation. 

        Sector Composition

        A Compelling Opportunity for Investors

        After lagging behind US large caps for several years, small and mid-cap stocks are gaining ground once again. Poised to potentially benefit from the Trump Administration’s policies, small and mid-cap companies now offer attractive valuations relative to large caps.

        Supported by strong consumer spending and robust small business sentiment, US small and mid-cap stocks tend to be more domestically focused, which both potentially insulates them from global economic uncertainties while allowing them to capitalize on a resilient US economy.

        Given the combination of macro tailwinds, reasonable valuations, expected Trump’s favourable fiscal policies, and strong domestic indicators, small and mid-cap segments may be well-positioned to benefit as 2025 progresses.

        Exposure to US Financials with SPDR: 

        ZPRR GY

        ZPRR GY

        SPDR® Russell 2000 U.S. Small Cap UCITS ETF (Acc)

        View Fund Details

        SPY4 GY

        SPY4 GY

        SPDR® S&P® 400 U.S. Mid Cap UCITS ETF (Acc)

        View Fund Details

        ZPRV GY

        ZPRV GY

        SPDR® MSCI USA Small Cap Value Weighted UCITS ETF

        View Fund Details

        More on Weekly ETF Brief

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