Small caps are surging, but their haven status is in jeopardy
Investors flocked to smaller firms amid trade jitters, but some question safety of the bet
Investors have pushed U.S. small-cap stocks to record highs while seeking a haven from tariff-related tensions, but the popular trade is beginning to appear vulnerable.
More than $4 billion poured into mutual funds and exchange-traded funds that track small caps in May and June alone, while U.S. stock-focused funds as a whole have suffered billions of dollars of outflows every month this year, according to data from Morningstar LLC.
That influx of cash has helped propel the Russell 2000, an index that tracks shares of smaller companies, up 11% this year, compared with the S&P 500’s 4.8% gain. The index is still trading near record levels, but some analysts warn that strong corporate earnings and economic data are masking the tariffs’ potential negative impact on small businesses.
At least half a dozen small, domestically focused companies, including motor-home manufacturer Winnebago Industries Inc., lighting firm Acuity Brands Inc. and agricultural machinery maker Art’s-Way Manufacturing Co., have said the recent tariffs imposed on steel and aluminum and a host of other Chinese goods threaten to disrupt their businesses.
“Right now, all this is muted because the U.S. economy happens to be growing very strongly,” said Mary Lovely of the Peterson Institute for International Economics. “Longer out, this is going to affect consumer spending and more importantly it’s going to affect investment in the U.S.”
Much of the stock market’s recent rally has been driven by momentum-based trading when investors pile into assets—like small caps and technology stocks—that already have made big gains. That type of investor demand can quickly evaporate, leaving the market vulnerable to a selloff, analysts say.
Small-cap stocks have become relatively expensive as a result of the rally. The Russell 2000 is trading at a forward price-toearnings ratio of 22.4 as of Thursday, compared with the S&P 500’s 16.6.
“You’re overpaying for a company that’s considered safe,” said Jeff Holzmann, managing director at iintoo, an international real-estate investment platform.
The Peterson Institute said its analysis of the most recently enacted tariffs found the vast majority apply to intermediate or capital goods, such as machinery and electrical equipment. That means U.S. firms that import those goods will pay higher prices, even if they are manufacturing their products domestically.
“You have firms that don’t look like they’re exporting directly,” Ms. Lovely said. “Right now the damage is containable in some sense because the dollar values aren’t huge, but they’re starting to get bigger.”
Winnebago, which has a market value of about $1.3 billion, said on its earnings call last month that the inflationary pressures caused by the tariffs are the “biggest unknown for many companies today.”
The Forest City, Iowa, company said it is particularly concerned that demand for its recreational vehicles could wane as consumers pay for the impact of tariffs.
“It will force them to make choices on where to spend their discretionary savings and dollars,” Chief Executive Michael Happe said. “We also take very seriously the price increases that we ask of the market because we’re fully aware that they could have an impact in the future in terms of slowing demand.”
Even though Winnebago purchases most of its steel and aluminum in the U.S., the company warned it expects cost pressures to continue in the current quarter. Those comments, though, were overshadowed by the company’s stronger-than-expected earnings in the latest quarter, spurring a 15% surge in shares on June 20.
Meanwhile, Acuity Brands and Art’s-Way Manufacturing also said earlier this month that their input costs have risen with steel prices. Acuity said it hopes to mitigate the impact by increasing prices and reducing costs. Art’s Way, which is a supplier to several multinational agricultural-equipment companies, said it has already been forced to raise its prices as a result.
Other companies, including industrial equipment supplier MSC Industrial Direct Co., furniture maker Herman Miller Inc. and consumer-products company Helen of Troy Ltd., also cited the tariffs as a concern on recent earnings calls. With the exception of Helen of Troy, the other five stocks have underperformed the Russell 2000 in 2018.
To be sure, multinational companies like Boeing Co. and Caterpillar Inc. would face the brunt of the impact from a trade war. Companies in the S&P 500, on average, get about a third of their revenue from overseas. That number is 21% for companies in the Russell 2000. Industry titans including General Motors Co., Alcoa Inc., Union Pacific Corp. and Harley-Davidson Inc. have warned that tariffs are disrupting their markets.
Jack Ablin, founding partner and chief investment officer at Cresset Wealth Advisors, has shifted into small-cap stocks as a safety play. His firm, which manages about $2.7 billion, has been selling foreign assets and rotating into domestic companies since the trade conflicts began.
But even Mr. Ablin acknowledges the shortcomings of that strategy.
“Investors who believe that this trade war is going to escalate and could impact the global economy would be better served not owning equities at all, at least for the near term,” he said.
Much of the stock market’s recent rally has been driven by momentum-based trading when investors pile into assets that already have made big gains