How Will Small-Caps Respond to Tariffs and Heightened Volatility?
article 02-04-2025

How Will Small-Caps Respond to Tariffs and Heightened Volatility?

CEO and Co-CIO Chris Clark details why tariff-driven volatility can ultimately help small-cap performance.

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February began with the markets swooning from President Trump’s announcement of tariffs on goods coming into the U.S. from China, Canada, and Mexico. From our vantage point as small-cap specialists, we think it is too early to gauge even the short-term impact on earnings and business fundamentals--both positive and negative—as the duration and impact of these tariffs is impossible to quantify. To take one example, Monday began with the president announcing the immediate levying of tariffs on some of the U.S.’s most important trading partners. Markets quickly fell into disarray before some measure of calm returned following reports that there would be a pause on tariffs for goods coming from Mexico following constructive negotiations. Later that day, a similar arrangement was reached with Canada.

In addition, early indications are that tariffs—at least those involving Canada and Mexico—are more focused on trying to solve non-economic issues such as the cross-border drug trade and immigration, so they may be short lived, assuming that the ostensible goals are met. As of this writing, the greatest areas of potential impact, if these tariffs are sustained, would be on the housing, auto, and farm sectors of the U.S. economy.

As active investors, we welcome a market environment that distracts investors from longer-term business fundamentals and economic value, which is often the case when markets experience elevated volatility. It allows for even greater distinction between companies that possess higher quality attributes compared to those that don't.
—Chris Clark

Our base case is that these tariffs are being used tactically and, while disruptive, will impact market sentiment, volatility, and risk taking more than longer-term business fundamentals. Regardless of their ultimate duration and scale, however, tariffs will hasten the now established trends of deglobalization, business reshoring to the US, and better supply chain management in U.S. manufacturing. All of which support our well-documented case for U.S. small-cap stocks regaining leadership in the market, driven by a meaningful upswing in small-cap earnings and supported by valuations far more attractive than found in other market capitalization or style segments. We’ll have more to say on the issues of valuations, earnings, and volatility in two weeks’ time.

We think it’s important, however, to discuss volatility as we believe we are entering a period of heightened uncertainty driven by the disruptive nature of both the rhetoric and policy proposals of the new Trump administration. We have often talked about how we welcome short-term volatility as a foundational element for building long-term, market-beating returns. One critical advantage of having been small-cap investors for more than five decades is how it’s bred a deep appreciation for the cyclical nature of markets and the long-term benefit of contrarian thinking. Bull markets, bear markets, and long periods of outperformance for one style or asset class—all are subject to cyclical dynamics, and none lasts forever. Understanding what drives inflection points and a willingness to think critically beyond the market's conventional wisdom are the underpinnings for generating long-term outperformance.

While still in the early days, many signals point to the likelihood that equities will experience heightened levels of volatility as we move further into 2025 and, if history is our guide, this bodes well for small cap's relative returns. Looking at subsequent average annualized returns for the Russell 2000 and the large-cap Russell 1000 following periods when the CBOE S&P 500 Volatility Index—aka the VIX or the ‘fear gauge,’—was elevated showed a positive edge for small-cap stocks. Our research revealed that the percentage of periods when the Russell 2000 had better average annualized 3-year returns than the Russell 1000 were at their highest following periods of heightened volatility.

Russell 2000 vs Russell 1000 Monthly Rolling VIX Regimes
Subsequent Average 1-Year Return Periods After VIX 1-Month Average was ≥ 28% from 12/31/89 through 12/31/24

Subsequent Average Annualized Three-Year Return for the Russell 2000 Starting in Monthly Rolling VIX Return Ranges

VIX was ≥28% in 44/408 periods. Source: Bloomberg.
Past performance is no guarantee of future results. The chart above measures the average returns and spread of the monthly trailing three-year return periods in month where the monthly average three-year VIX level falls within the specified range. The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days, and is quoted as an annualized standard deviation.

In addition, as active investors, we welcome a market environment that distracts investors from longer-term business fundamentals and economic value, which is often the case when markets experience elevated volatility. It allows for even greater distinction between companies that possess higher quality attributes compared to those that don't. As we enter 2025, we remain highly constructive on the backdrop for small-cap equities and for our differentiated and highly active approach to constructing our portfolios.

Important Disclosure Information

Mr. Clark’s thoughts concerning recent market movements and future prospects for small-company stocks are solely those of Royce Investment Partners, and, of course, there can be no assurances with respect to future small-cap market performance. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The CBOE S&P 500 Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It is the square root of the risk-neutral expectation of the S&P 500 variance over the next 30 calendar days and is quoted as an annualized standard deviation. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The performance data and trends outlined in this article are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements. Investments in securities of micro-cap, small-cap, and/or mid-cap companies may involve considerably more risk than investments in securities of larger-cap companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) Investments in foreign companies may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in International Securities" in the prospectus.)

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