Reloading the small-cap reopening trade, post-Delta

The spread of a more contagious COVID-19 variant through 2021 dampened some of the enthusiasm about an economic reopening in the market, but its impact was selective. For the biggest stocks, it didn’t seem to matter at all: the S&P 500 surged to a record after Federal Reserve chair Jerome Powell’s Jackson Hole speech signalled no desire to bring forward the timetable for tapering asset purchases, in part because of the Delta variant’s threat to the real economy.

Smaller stocks are in a quite different place, though. The Russell 2000, which has less exposure to tech and consumer staples than the S&P 500, has been range-bound since February. We don’t think that underperformance is justified, given the likelihood that vaccinations keep powering forward and economies around the world continue to reopen – even as negative virus headlines continue to emerge from the US.

A recent example of that news flow came when the Delta variant’s spread through the US led the EU to restrict non-essential travel from the world’s biggest economy. Still, we think we are close to ‘peak US Delta’, even with the risks stemming from children returning to schools. The UK’s experience is a positive precedent.

Another indicator we watch is Google searches: in the US, the search engine’s enquiries about the Delta variant have peaked.

This has left small-cap valuations at the attractive end of their 10-year trading range, in our view. Sentiment in this sector shows slight bearishness, and the adjustment away from extreme bullishness in the past few months is one of the sharpest on record.

The UK’s experience also shows how this small-cap gap can close. In both the UK and the EU, small-caps have performed roughly in line with their respective large-cap peers in 2021, and are significantly ahead of their pre-pandemic and pre-vaccine levels. In this international context, the US underperformance is an outlier.

The true headwinds for US small-caps should come later in the cycle, in our view. A tighter labour market should mean rising wages for a group of companies with a higher proportion of US workers. When monetary policy eventually tightens, small-caps are more sensitive to a credit-crunch scenario, and are consistently negatively correlated with high-yield spreads.

However, we aren’t there yet: we believe we’re in a mid-cycle environment – as is especially clear in the wake of Powell’s dovish speech.

Finally, as investor sentiment improves, don’t discount a return of the Reddit and Robinhood crew. Traders of ‘meme stocks’ that made headlines at the start of 2021 were focused on smaller companies. Meme-stock activity has been lower recently, as seen by the underperformance of the Goldman Sachs Retail Favorites index.

The small-cap catch-up could take a year, but is likely to kick in much more quickly than that. As a result, we are minded to go long US small-cap stocks versus the broader market.