US small-caps find a silver lining in tariffs

Liseth Galvis - 14 March 2018

On the first of March Donald Trump announced significant trade tariffs on imports of steel and aluminium – at 25 per cent and 10 per cent respectively. Since then the Russell 2000 has appreciated by 4.4 per cent and the S&P 500 by 3.7 per cent (figure 1). The Russell 2000 measures small- cap stocks, which have higher revenue exposure in the US and less exposure abroad. By contrast, the S&P 500 measures large-cap stocks, which are more exposed to international trade. 

From March 2002 until December 2003 President George Bush imposed trade tariffs of up to 30 per cent on steel. During this period, the Russell 2000 appreciated by 11 per cent and the S&P 500 decreased by 3 per cent. The measures were removed because the World Trade Organization (WTO) announced that the tariffs were illegal, and Bush did not want to generate a trade war. Unlike Bush, it seems that fears of trade war retaliation from other countries are not a concern for Donald Trump. From his perspective, “trade wars are good and easy to win”.

With a US economic outlook is clouded by these protectionist measures, it is instructive to look at small caps, which tend to be less affected by them.

Another factor contributing to the momentum of the small caps is the prospective gains derived from upcoming tax reform. The reduction of US corporate tax from 35 per cent to 20 per cent will benefit small caps disproportionately because they face higher overall tax rates than large-caps. According to Thomson Reuters, overall companies in the small-cap benchmark Russell 2000 index pay a median effective tax rate of 32 per cent, while the larger companies in the S&P 500 pay a median effective tax rate of 28 per cent.

Figure 2 shows the ratio between the RBX and the VIX. The RBX measures market expectations of near-term volatility of the Russell 2000. In the case of the S&P 500 this variable is measured by the VIX. The ratio indicates the relative volatility level of small-cap versus large-cap stocks. The ratio has decreased substantially, from 1.56 in October 2017 to 1.05 in March 2018, suggesting that small caps are no longer perceived as more volatile.

This trend accentuated between the 1st and 9th of February 2018, when markets declined substantially in the face of a more visible inflationary threat and ensuing increasing interest rate expectations. In this period the RBX/VIX changed from 1.31 to 0.9, respectively. This is the lowest figure observed in the ratio since August 2015. As volatility returns to markets as part of the end of the low interest rates era, it is likely that large-caps will be more affected than small-caps.

Trade tariffs will be effective 15 days after the announcement, limiting the time available to implement contingency plans. The most vulnerable stocks belong to companies that have exposure to countries that are not part of the exemption list (Mexico and Canada). Currently the EU, Japan and the UK are pressing for their exemption. While the risks of escalation in reaction to the US tariff announcements are not to be dismissed lightly, there is a silver lining in the prospective outperformance of the small-cap stocks that populate the Russell 3000.


Figure 1

Data source: Thomson Reuters Datastream

Figure 2

Data source: Thomson Reuters Datastream



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