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        Weekly ETF Brief

        US Small- and Mid-cap Equities: Softer Economy, Softer Inflation, Softer Fed?

        The softening of the still robust US economy and its labour market may turn into a tailwind for US small and mid caps, which have become increasingly yield sensitive as inflation, not recession, is the number one worry for the US equity market.

        3 min read
        Krzysztof Janiga, CFA
        Senior Equity ETF Strategist

        We have long argued there is a solid strategic case for a broadening of market performance for mid and small caps. But if inflation doesn’t overshoot expectations, the next several weeks may also present an interesting tactical entry point as the Federal Reserve (Fed) has been given several reasons to become less hawkish. 

        Favoured in Balanced Environments

        The relationship between inflation prints and the performance of small and mid caps relative to large caps is nuanced and requires an understanding of the broader economic backdrop. Since end of 2022, the Russell 2000 Index and the S&P MidCap 400® Index typically outperformed the S&P 500® Index when inflation came in either at or below expectations, but only in periods when growth concerns were limited. We saw this environment from the beginning of June until the end of July 2023, and then again at the end of the year. Looking at the period between February and the end of May 2023, neither decreasing yields nor lower-than-expected inflation were sufficient enough to trigger outperformance, as concerns related to the regional banking crisis and the debt ceiling debate overshadowed decreasing inflation. Thus far in 2024, we’ve seen underperformance as yields in general have moved up and inflation has overshot in most months. In short, small and mid caps need a combination of growth and disinflation.

        Now, the US economy may be striking the right balance as growth is not collapsing but is slowing enough to limit inflation pressures from the demand side. This may lead to a more dovish Fed narrative which, in our view, could turn into a significant tailwind for US small and mid caps. While the May non-farm payroll number exceeded expectations, other datapoints have been encouraging, with flat retail sales, falling job openings, and spending at +0.2% in April.1 

        It is worth noting that the dispersion of relative returns for the S&P MidCap 400® Index versus the S&P 500 Index is lower compared to relative performance of the Russell 2000 Index. This is fairly intuitive, given the bigger size of mid caps. Finally, underperformance relative to large caps in multiple periods also needs to be put into the context of very strong performance from tech giants that drove S&P 500 gains over the last year and a half.

        Figure 1: Russell 2000 and S&P MidCap 400 Index Performance Relative to S&P 500 One Month Following an Inflation Print

        Figure 1 shows the dispersion of relative returns for both small and mid cap indices relative to large caps to see if there is a relationship between performance and inflation.

        Yield Sensitivity Increased as Growth Worries Receded

        The 30 day correlation between the performance of small and mid caps with the US Government 10-year yield change has become increasingly negative. This was not the case between February and June 2023, when markets anticipated a recession in the US. However, as growth expectations were sharply upgraded throughout last year, investor attention turned to inflation dynamics. With softening pressure from the demand side, this inverse correlation may allow small and mid caps to prosper. The key risk here is that the US economy could see a negative surprise on the inflation front which could (not for the first time in this cycle) lead to a revision of the interest rate path.

        Longer-term Opportunities

        In the near term, a hard landing or even a no-landing outcome is not off the table. But US data implies an increasing probability of a soft landing scenario, and small caps are tailored for this. 

        In the long run, we would not be surprised to see the end of the decade-long large cap dominance, given both the Russell 2000 and the S&P MidCap 400 are more domestic, allowing investors to access US exceptionalism in a more direct way, regardless whether it’s driven by consumer or fiscal spending. The latter element is also linked to the geopolitical backdrop, as increased fragmentation will likely lead to gradual but prolonged reshoring efforts, which will require public spending and will benefit more domestic players. 

        Finally, undemanding valuations may allow investors to benefit not only from size but also from value rotation. We recently elaborated on the long-term investment risks and opportunities of both small and mid caps in the US and beyond in a Weekly ETF Brief last month.

        How to Access US Small and Mid Caps

        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

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