Down 10% from the peak! Small-cap stocks in the "Trump trade" have lagged behind

As President Trump is about to begin his second term, investors are looking forward to the performance of small companies under his policies.

However, the recent performance of small-cap stocks has been disappointing. The Russell 2000 Index has fallen 10% since last November, while the S&P 500 Index, which serves as a benchmark for large-cap stocks, has only dropped by less than 3%.

Trump's economic agenda is widely regarded as beneficial for domestic economic growth, which theoretically should boost the performance of small-cap stocks. Keith Lerner, co-chief investment officer at Truist Advisory Services, pointed out, "In a strong economy, small-cap stocks typically perform better."

However, recent expectations of high interest rates have put pressure on small companies. Due to the higher debt levels of small companies, rising borrowing costs may suppress their growth potential.

Can Small-Cap Stocks Catch Up?

Despite the challenges facing small-cap stocks, a recent positive inflation report has eased market concerns about Treasury yields, providing some breathing room for small-cap stocks and the overall stock market.

After Trump's election in 2016, the Russell 2000 Index soared and continued to outperform the S&P 500 Index in the year following Trump's first victory, rising 24%, while the large-cap index increased by 21%.

Although small-cap stocks performed well after Trump's initial election, the current economic situation complicates their outlook. Sameer Samana, senior global market strategist at Wells Fargo Investment Institute, noted that the Trump administration's tax cuts and deregulation may benefit small companies, but its preference for tariff policies could pose risks to small companies due to supply chain disruptions.

With Trump's re-election, the market initially had confidence in his pro-business policies, and the S&P 500 has risen 3% since the election. Meanwhile, "Trump trades" like Tesla remain active, with its stock price rising over 60% since November 5.

However, expectations of rising interest rates are dampening sentiment for small companies. The Federal Reserve's December forecast indicated that the number of expected rate cuts this year would be reduced, which has impacted confidence in small-cap stocks. Yung-Yu Ma, chief investment officer at BMO Wealth Management, stated:

"Small companies tend to be heavily indebted and have not benefited from lower interest rates, which has poured cold water on the strong performance of small-cap stocks."

Investors in small-cap stocks hope to catch up with the S&P 500 in the future, especially given that the S&P 500 has risen nearly 50% over the past two years, while the Russell 2000's increase has been only half of that.

Although small-cap stocks have the opportunity to stand out under Trump's policies, Truist's Lerner reminds us that small-cap indices tend to be more weighted towards financials and industrials, which are relatively more sensitive to higher interest rates and inflation.

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