In a trade fight, small could be beautiful again

The shares of small and medium-sized companies have performed badly, but should eventually benefit from strong U.S. productivity growth.

  • By Jon Sindreu,
  • The Wall Street Journal
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Until recently, investors saw smaller companies as a trusty shield against trade tensions. Given the health of the U.S. domestic economy, they should see them that way again.

Small and mid-capitalization stocks—those with a market value less than roughly $5 billion—have performed badly over the past year. The S&P Small Cap 600 (.SML) and the S&P Mid Cap 400 indexes (.MID) have returned a negative 5% and 1% respectively, compared with a 6% gain for the S&P 500 (.SPX). Something similar has happened in Europe.

Their poor showing in this year’s stock-market recovery is particularly striking. Small-cap stocks tend to be a more volatile version of their larger peers, rising more in rallies and falling more in selloffs. The explanation is that the rebound has been a cautious one. Money has gone mostly to high-quality companies—a sign that the rally was mostly a reaction to last year’s exaggerated selloff.

Now market sentiment is being depressed by the U.S.-China trade fight, which smaller companies offer some hedge against. Almost 80% of revenue made by companies in the S&P Small Cap 600 comes from the U.S., compared with roughly 60% for the S&P 500.

It’s true that analysts have sometimes overplayed how protected smaller companies are, given that many supply larger multinationals. Analysts at Morgan Stanley (MS) point out that small firms have fewer levers to pull to adapt to lower sales and higher costs.

This may explain the bout of small-cap underperformance as corporate sales have stalled and wages have risen this year. A record share of members of the National Federation of Independent Businesses now cite labor costs as their single biggest problem. Earnings expectations for companies in the S&P Small Cap 600 have dropped, according to FactSet.

But higher labor costs also mean richer consumers. Evidence is building that stronger wages can spur faster productivity growth, as higher consumer spending allows firms to operate closer to full capacity while encouraging them to innovate and mechanize production.

This is likely already happening in the U.S. Rising labor costs have just started to be accompanied by a much-anticipated pickup in productivity. This may benefit large corporations first, but small-caps will soon follow. And they are still unlikely to be targeted by China in any high-profile trade retaliation policy.

As cautious as investors may want to be, owning stocks right now is a bet that the domestic economies of developed countries will remain robust despite the trade spat—which is the case so far, even in Europe. That logic applies even more to smaller companies than it does to their larger brethren. Small-caps deserve a reassessment.

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