How the Trade War with China Is Affecting U.S. Small Caps—and What the Future May Hold
Tina Jones, CFA
Chief Investment Officer
Rothschild & Co.
With the ongoing trade war, what do you think is the attractiveness of U.S. small cap stocks?
Smaller companies generally have less direct exposure to China than larger companies because they tend to be domestically oriented. To illustrate, approximately 80% of revenues for companies included in the Russell 2000® Index are generated in the U.S. compared to about 50% for companies included in the S&P 500® index. This exposure implies they are well positioned to weather disruption in trade with China.
What disadvantages could small caps have during this trade dispute?
The biggest disadvantage is smaller companies that do business in China generally don’t have as much ability to renegotiate manufacturing costs because they don’t have the scale. But for small caps, we believe their general lack of exposure to China trumps any disadvantage they have in reducing supplier costs.
What types of small-cap sectors might be considered good defensive positions?
This is fairly universal, but they would certainly include Utilities, Real Estate, Financials, Health Care, Consumer Discretionary, and Consumer Staples. Remember, you always need to turn on the lights, pay your rent, and buy toothpaste. If you think about American companies that provide services to the U.S.—and their primary cost is domestic labor—those companies are largely insulated.
Are there small-cap sectors that could be worrisome for investors?
I believe there are areas in the Information Technology sector that will likely be vulnerable: semiconductors, software, tech hardware, and equipment. However, we have seen some software companies—especially those selling intellectual property—do fairly well and will likely do well in the short term because China wants its IT. And now, if President Trump enacts his proposed 10% tariff on another $300 billion in Chinese goods, the Consumer Discretionary sector—including smartphones, retailers, and toys—would be impacted in some way.
How have small caps adjusted to this new reality?
It’s been interesting because the trade war creates uncertainty, and uncertainty is usually not good for growth. But we really haven’t seen companies change their business plans, their hiring, or make any meaningful cuts yet because of the trade war. U.S. small-cap companies have done a good job of absorbing these tariffs, mostly by reducing supply-chain costs.
Why have companies been able to reduce their manufacturing costs in China?
Chinese suppliers are already starting to feel the heat as manufacturing moves out of the country. This means there’s more capacity, and these companies want to fill that capacity, even if they have to do it at a lower price.
What if the trade war continues to escalate?
U.S. gross national product would be impacted, but you could argue that China’s gross national product would be severely impacted. About 70% of new jobs created in China come from the private sector, and those jobs are supporting a very robust export economy. Moreover, Chinese exports to the U.S. represent 23% of all Chinese exports. If that were to significantly shrink, doing business in China would be far less profitable, and you might see sales compress dramatically. In comparison, U.S. exports to China represent only 7% of our total exports.
Are there any silver linings for small caps during this trade war?
If companies diversify their supply chains, in the long run it’s a positive because it will be much harder to be held hostage in any situation. Additionally, what this diversification does at the stock level is support multiples. Maybe not earnings, but multiples. We’re probably not going to see as much volatility because the investment community will likely say, “Okay, this is a one- or two-year phenomenon, and we’ll get through this. It’s not like the world is coming to an end.”
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Multiples provide statistics that can be used to evaluate relative value across sectors, industries, and asset classes and may include price-to-earnings, price-to-book, and price-to-cash flow, among others.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The S&P 500 index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market.
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