As the prospect of a U.S. trade war with China moves from rhetoric to reality, many investors have sought a safe harbor from any economic fallout that may adversely impact U.S. corporations. The haven of choice for queasy investors has recently been the small-cap sector. Last Tuesday’s price drops in the S&P 500 demonstrate that U.S. stocks with China exposure are sensitive to trade fears. Only one out of the 14 S&P 500 companies that earn more than 25% of their revenue from China fell by more than the index.
Concerns about weaker global economic growth and the economic impact on larger capitalized corporations are driving investors to the relative safety of smaller cap companies whose revenue is generated primarily from domestic operations.
Larger companies have greater exposure to the negative financial ramifications of a trade war. Figures provided by data FactSet show approximately 38% of S&P 500 companies earnings are generated from overseas operations; for companies in the S&P Small Cap 600 that figure is 20%.
When China said it would retaliate against U.S. car makers and industrial companies in response to President Trump’s imposition of tariffs on $200 billion of Chinese heavy goods, shares of Caterpillar (CAT, Financial), Boeing (BA, Financial) and John Deere were hit. Indeed, Caterpillar has evolved into a barometer of investors' mercurial sentiments concerning the outcome of trade tensions between China and the U.S., rising or remaining stable on news viewed as neutral or inconclusive, declining on more ominous-sounding rhetoric.
Returns on the small-cap indexes clearly indicate that investors favor their relatively greater immunity from the effects of tariffs and other restrictionist trade measures: The S&P Small Cap 600 has advanced 12.4% since the beginning of the year, hitting a new record high, compared with a 3.5% gain for the S&P 500. The Russell 2000 has gained 11.2% for the same period.
The swift rise in small caps isn’t confined to the U.S. The MSCI Europe Small Cap Index has risen 2.3% year to date, compared to a 1.5% decline in the broader MSCI Europe Index.
The heady rise of the smaller cap sector indexes in the midst of the uncertainties generated by a looming trade war indicates that these companies are viewed more favorably by investors due to their relatively limited exposure to economic conditions overseas. Investors have taken notice of the substantial increase in earnings and profit margins of many of the small cap firms. Their growth was turbo charged by the tax cuts that benefited the smaller companies disproportionately, an economy that had not slowed and robust consumer spending.
After last year’s corporate tax cuts in late 2017, a survey of small business profitability in May hit its highest reading since records started in 1973, according to the National Federation of Independent Business. Additionally, expectations about future expansion were also the most optimistic in the survey’s history.
The return for small caps is a remarkable reversal in fortunes as investors infused cash last year into large multinational companies they believed were better positioned to reap the rewards from a synchronized pickup in the global economy.
This scenario has now been reversed: Growth in the eurozone has slowed and Japan’s economy has contracted, which would end the longest growth streak in 28 years.
I have no position in any of the securities referenced in this article.
