By Krzysztof Janiga, CFA, Senior Equity ETF Strategist at SPDR: As valuation levels in large caps became extreme, the market rally began to broaden with investors searching for opportunities across sectors and market cap segments. Small-cap companies may be well positioned to benefit from that broadening given inexpensive multiples, catch-up potential, cyclical sector composition and more domestic profiles in the deglobalizing world. While there are many commonalities among small caps, no two exposures are the same and, as such, each region is exposed to specific risks and opportunities.
US Small and Mid Caps: Dovish Signals and Long-term Resilience
In this stage of the cycle, inflation prints will continue to dictate small-cap performance. US small caps sold off in April as the CPI overshoot led to increasingly hawkish bets and yield expansion. Since then, we observed a rebound driven by several dovish signals including: 1) the May Federal Reserve (Fed) meeting, which was less hawkish than feared; 2) softer-than-expected Q1 US GDP growth at 1.6% annualized rate and 3) wage growth moderating to 0.2%. While CPI overshoots remain a key risk for equity markets including small caps, recent data prints advocate for the possibility of a more dovish outcome than currently priced in by the markets.[1]
US GDP growth softened, but the Q1 print did not end the US exceptionalism story as growth continues to be much higher than in other parts of the developed world driven by consumption, which, thanks to labour markets, remained remarkably resilient against tight monetary policy. Economic expansion in the US has been chronically underappreciated, leading to continuous upgrades of GDP forecasts for 2023 and 2024.
Figure 1: Bloomberg Consensus US GDP Growth Forecast Evolution
Moderating wage growth combined with the low unemployment is a goldilocks scenario for small caps. The 0.2% monthly growth in wages combined with productivity gains may allow the Fed to make a dovish turn in July or September, while remarkably low unemployment at 3.9% supports domestic consumption. In the long run, the labour market’s resilience is fundamental for more domestic and cyclical small and mid caps prospering.
Figure 2: US Inflation and Unemployment
Small- and mid-cap indices generate between 76% and 79% of their revenue within the US, while the corresponding number for the S&P 500® Index is 59%[2]. This makes the Russell 2000, MSCI USA Value Weighted and S&P MidCap 400 indices more direct tools to access US exceptionalism. But each strategy has a unique profile:
- The S&P MidCap 400 Index overweights more traditional companies — Industrials is the largest sector — which is appealing in the context of rebounding ISM readings. Longer term, public spending in the form of the Infrastructure Investment and Jobs Act, the CHIPS and Science Act, the Inflation Reduction Act, and broad reshoring efforts are likely to benefit more domestic and industrial-heavy mid and small caps.
- The Russell 2000 Index overweights biotech and software companies, which often are in the earlier stage of development. This means the index has, in our view, a higher risk-return profile.
- The MSCI USA Small Cap Value Weighted Index is skewed towards financials, which represent more than a quarter of the index.
The common characteristics of the three indices is a cyclical and less tech-heavy sector split, which may be a tailwind if the hard landing is avoided and broadening of market rally continues.
Figure 3: US Small and Large-cap Index Sector Breakdown
How to Access US Small and Mid Caps
SPDR® S&P® 400 U.S. Mid Cap UCITS ETF (Acc)
SPDR® Russell 2000 U.S. Small Cap UCITS ETF (Acc)
SPDR® MSCI USA Small Cap Value Weighted UCITS ETF
European Small Caps: Upcoming Cuts and Improved Growth Create Opportunities
The backdrop for European small caps has notably improved on an absolute and relative basis over the course of 2024. Inflation in Europe is moderating more convincingly than in the US, making June rate cuts a base-case scenario in the Eurozone and in the UK. The Riksbank and the SNB have already begun the easing process providing a tailwind to risky assets. Easing in Sweden is of particular importance given structurally short debt maturity schedule.
While disinflation is a most welcome but ongoing theme, the improvement to the investment backdrop which we didn’t observe earlier comes from better-than-expected economic activity. Germany avoided recession in Q1 and GDP growth in France at +0.2% and Spain at +0.7% in the first quarter exceeded estimates. In the UK, recession ended with GDP jumping by 0.6% quarter-on-quarter — the strongest growth since the end of lockdown. On balance, the economic activity is likely to remain much more muted than in the US. However, with rate cuts on the horizon, improvements to the economic outlook and lack of recession are becoming significant tailwinds to European small caps in our view.
Small caps in Europe are trading at inexpensive multiples compared not only to large caps but also to their own history. The forward price-to-earnings (P/E) at 13.0x is in the second-lowest decile for the last 10 years. Over that period, on average, the MSCI Europe Small Cap Index traded at a 9% higher P/E multiple than the MSCI Europe Index. It currently trades at a 7% discount — one of the lowest levels in 10 years. These levels may provide an interesting entry point as rate cuts are at hand while the European economies are holding up better than expected.
Figure 4: Price-to-earnings 1y Forward
The MSCI Europe Small Cap and MSCI Europe Small Cap Value Weighted indices generate respectively 66% and 69% of their revenue within Europe, making them more domestic exposures compared to the MSCI Europe Index at 42%[3]. From a regional standpoint, small-cap indices overweight the UK and Sweden while the most significant underweights are France and Switzerland.
Perhaps the most important distinction lies in the sector composition, with Industrials representing nearly a quarter of small-cap exposures. The sector is supported by long-term tailwinds including green transition, energy security, and reshoring. Another important overweight is Real Estate, a battered sector which may enjoy a rebound as the battle against inflation in Europe is being won and central banks across the continent are clearly more keen to cut interest. The underweight towards Health Care and Consumer Staples makes European small caps a more risk-on exposure from the sector standpoint.
Figure 5: Sector Composition
How to Access European Small Caps
SPDR® MSCI Europe Small Cap UCITS ETF
SPDR® MSCI Europe Small Cap Value Weighted UCITS ETF
Global Developed Small Caps: Diversified Exposure With Undemanding Valuations
The MSCI World Small Cap Index combines US small caps (representing 60% of the exposure) and European small caps (accounting for 18%). This helps to balance risks and opportunities associated with each region. The third-highest weight is Japan, representing 12% of the index — double its weight in the MSCI World Index. While the weakening Yen drove equity performance over the last two years, in 2024, “Shunto” negotiations led to strong wage growth, which is a tailwind for more domestic small caps. And the Tokyo Stock Exchange reforms are expected to increase efficiency among listed companies.
Figure 6: Country Composition
As CPI levels across the world gradually moderate and the outlook improves beyond the United States, the opportunity for a catch-up trade opens up. Valuations remain inexpensive, both on an absolute basis and in relation to the MSCI World Index. Finally, when it comes to potential broadening of performance, the MSCI World Small Cap Index is less concentrated than the MSCI World Index where the weight of the top 10 constituents is 1.9% versus 21.5%, respectively[4].
Figure 7: Price-to-earnings 1y Forward
How to Access Global Developed Small Caps
SPDR® MSCI World Small Cap UCITS ETF
Emerging Markets Small Caps: More Direct Access to Economic Growth
Emerging market (EM) economies continue to outpace the developed world. Yet EM equity returns have been poor, dragged down by Chinese stocks that face numerous challenges, including the reemergence of technology crackdown, geopolitical tensions, and slower-than-expected economic activity. And while Chinese equities rebounded over the course of the year, geopolitical and regulatory risks remain in place.
The MSCI EM Small Cap Index offers a simple solution to those risks and headwinds by heavily underweighting China, which accounts for only 8% (versus 27% for the MSCI EM Index — see Figure 8). Instead, India, which is the fastest growing major economy, represents 27%. Rapid growth and the need for diversification in supply chains make India an attractive place for foreign capital, which is expected to flow into the country over the medium term in various forms. The second-most important overweight is Taiwan at 22% of the index. While geopolitical risks need to be monitored, Taiwan remains an indispensable part of the semiconductor supply chain. The third-highest overweight is South Korea, a powerhouse in technology offering access to a wealth of high-quality companies.
Figure 8: Country Composition
The country breakdown has been the key driver of the MSCI EM Small Caps Index outperforming the MSCI EM Index in recent years, and we expect it to remain a tailwind until there is sustainable improvement in the geopolitical and regulatory landscape of China.
Moreover, EM small caps also generate a larger share of their revenue domestically, allowing for more direct benefit from relatively robust EM economies. The MSCI EM Small Cap Index is well diversified with the top 10 companies representing only 3% (versus 25% in the MSCI EM Index)[5]. Moreover, state-owned companies, which may be less efficient, account for only 8%; the corresponding number for the MSCI Emerging Market Index is 23%[6].
Figure 9: Performance Since the End of 2019
How to Access Emerging Market Small Caps
SPDR® MSCI Emerging Markets Small Cap UCITS ETF
Footnote
[1] Bloomberg Finance L.P., as of 30 April 2024.
[2] FactSet, as of 31 March 2024.
[3] FactSet, as of 30 April 2024.
[4] MSCI, as of 29 March 2024.
[5] MSCI, as of 30 April 2024.
[6] MSCI, as of 31 October 2023.
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