US Small Caps: From UW to neutral on macro tailwinds

We are reversing our long-held bias against US small caps and returning to a neutral outlook. Improving macro tailwinds and inflows provide a moderate tailwind, but crowding is already relatively high in small cap equities despite much lower quality. On balance, this should be a better environment for active selection within small caps to take advantage of improving macro while sidestepping the crowding and quality headwinds.

Small cap underperformance against large cap equities has been a persistent trend over the past 10 years (first chart), punctuated by periods of outperformance tied to the liquidity cycle. This liquidity effect can be seen via our Business Cycle Financing Index (second chart). Periods of synchronized global central bank easing have historically led to a more reflationary environment, resulting in small cap outperformance. 

Small cap outperformance also tends to coincide with broad-based improvements in economic expectations, which can be proxied using the ZEW economic expectations survey (first chart). Today, we are seeing economic expectations recover from the lows seen after Liberation Day, but there is still plenty of room for the survey to improve. Our adaptive US growth leading indicator has remained resilient at just below 2% annualized growth, well above the Conference Board leading indicator (second chart). This suggests that as the US economic data remains resilient, there is room for economic expectations to recover, providing a tailwind for small caps. 

To zero in on which data series matter the most for small caps, we ran our adaptive LEI engine on the small cap vs large cap equity ratio. The engine found two intuitive data series to track: the NFIB series on being unable to fill job openings and the NFIB series on interest rates paid on short-term loans. As the below charts show, small businesses are starting to get relief on labor pressures and interest rates, which has historically led the small vs large cap ratio by ~12 months.

The price action in small caps is also indicative of a meaningful rotation into small cap equities. One way to proxy for the intensity of inflows is to track the difference in upside and downside sensitivity of small caps relative to the S&P 500. If the Russell 2000 starts to rise much more on S&P 500 up days, while not falling by much on S&P 500 down days, then that is a pretty good indication of inflows into the Russell 2000. As the charts below show, the intensity of inflows into the Russell 2000 has jumped over the past month. Since 2021, we have seen a few false dawns for small cap inflows, but the liquidity backdrop today is much better than it has been at any point since 2021.

Although the above set up is encouraging for small cap equities, there are still a few reasons to not get overly excited. Consensus earnings forecasts already embed a decent EPS recovery for small caps. Much of the Russell 2000 constituent stocks are loss-making, but if we only isolate the positive EPS, the 2-year forward consensus growth rate is around 20%, compared with around 11% for the S&P 500. This shows that there is already a decent amount of optimism embedded.

Our Crowding and Quality scores also signal reason for caution. The VP Quality Score for the Russell 2000 remains at multi-year lows even as Crowding has jumped higher (first chart). In contrast, the S&P 500 has a much higher Quality score, while Crowding is nearer the lower end of the post-Covid range (second chart).

In summary, the macro tailwinds and inflows are likely to be meaningful drivers of small cap outperformance, but the structural quality problems remain. This is likely to be a good environment for active selection within small caps to take advantage of improving macro while sidestepping the Crowding and Quality headwinds.