Small Caps amid Trade Tensions

Tariffs continue to be among the biggest headline-grabbing issues these days. Tensions have hung in the air for months, escalating yet with the Trump administration’s recent decision to tack on 25% duties on another $16 billion in Chinese imports starting late August. Tariffs have been mentioned by 44% of the S&P 500 companies that have reported second-quarter earnings as of July 25, though the degrees of concern vary: Many of these companies anticipate “little to no impact in future quarters,” while some are expecting at least a “modest” negative impact on business and some are uncertain of the implications. Nonetheless, it is clear that an increasing number of businesses are starting to feel the effects and burdens of Washington’s tough trade tactics.

The view at Kayne Anderson Rudnick is that these trade conflicts will drag on for a while. What we’re seeing in terms of an impact right now is the increase of costs for steel, raw material and freight. We’re seeing the effects starting to play out as prices are moving higher on various consumer goods, ranging from sodas to solar panel installations. In sum, trade conflicts and increased tariffs will have a more negative impact on business activity overseas, especially those that are more dependent on trade as the U.S. dollar’s strength drives down the value of other currencies.

No particular asset class is immune to the effects, but everything is relative. Larger companies that engage in significantly more business in foreign markets will feel a greater impact than smaller businesses that are focused more on domestic operations and less exposed to foreign exchange.

Small caps, in fact, have outperformed their large-cap counterparts meaningfully this year and since trade disputes started to surface in earnest, in March. The Russell 2000 Index since March through the end of July has returned 11.05%, versus the S&P 500 Index’s 4.56% (see graph for a comparison of the indices’ cumulative growth).

It is clear investors have pushed U.S. small-cap stocks up while seeking refuge from tariff-related volatility. Again, no asset class is entirely protected from the ongoing disputes, as even small caps can face the burden of rising costs. Markets also will have to be observed for longer to determine whether or to what degree strong earnings and economic data had covered up the tariffs’ potential negative impact on small caps. But the small-cap space does remain the better positioned group in the current environment, one in which the KAR investment team’s approach of picking individual high-quality stocks is an appropriate protection today.