Small Caps Are Back | Animal Spirits 448

Markets are currently navigating a complex mix of signals. On one hand, we are witnessing a significant rotation where small caps are finally outperforming the tech giants that have dominated for years. On the other, geopolitical headlines—ranging from tariff threats to unorthodox territorial acquisition strategies regarding Greenland—are injecting volatility into the daily tape. While futures may dip and gold may surge in response to political instability, the underlying economic engine tells a different, more resilient story.

Key Takeaways

• The Rotation is Real: Small cap stocks (Russell 2000) have shown significant momentum, outperforming the S&P 500 and NASDAQ recently, signaling a broadening of market participation.
• Geopolitics vs. Fundamentals: While headlines about tariffs and borders cause short-term indigestion and volatility (spiking gold and the VIX), corporate earnings and GDP growth remain the primary drivers of long-term returns.
• Yield Curve Steepening: Bond yields in both Japan and the U.S. are rising. While often viewed negatively, this can also signal expectations of robust economic growth rather than just inflation scares.
• The "Hot" Economy: With fiscal, monetary, and credit policies potentially aligning to stimulate growth, the U.S. consumer balance sheet remains historically strong compared to previous peaks like 1999.

The Resurgence of Small Caps

For years, the market narrative has been dominated by the "Magnificent 7," resulting in historic concentration at the top of the S&P 500. However, recent data suggests a passing of the baton is underway. The Russell 2000 recently marked an 11-session streak of beating the S&P 500, a level of consistent outperformance not seen in some time.

Since the market lows in April, the Russell 2000 is up over 50%, outpacing large-cap indices. This shift is notable because small caps typically carry more interest rate sensitivity. The fact that they are rallying despite the long end of the yield curve steepening suggests investors are positioning for economic re-acceleration rather than just rate cuts.

The Earnings Anomaly

An interesting quirk in this rally is the quality of the companies leading the charge. Conventional wisdom suggests that in a high-rate environment, investors would flock to high-quality small caps (like those in the S&P 600) with positive earnings. However, data from Apollo indicates that within the Russell 2000, companies with negative earnings have dramatically outperformed those with positive earnings.

While this speculative behavior might raise eyebrows, it aligns with a "risk-on" rotation where the most beaten-down assets often stage the most violent recoveries. After four years of sideways movement, small caps may simply be due for their moment in the sun.

Geopolitics: Noise or Signal?

Recent volatility has been exacerbated by geopolitical headlines, specifically discussions regarding the U.S. interest in purchasing Greenland and the subsequent tariff threats against European nations. While the premise may seem unorthodox, the market reaction—gold surging and VIX rising—indicates that investors are using precious metals as a hedge against political instability.

The Historical Perspective

It is easy to suffer from recency bias, assuming the current world order is immutable. However, looking back at history provides a sobering reminder of how quickly global dynamics can shift. In the book 1913: In Search of the World Before the Great War, the author describes a Europe that felt invincible and interconnected just before it tore itself apart.

"To be a European, a European man in particular, was to see oneself at the center of the universe from which all distance was measured and against all of clocks were set... Past civilizations might have built great cities... but none could compare to the material and technological culture to which Europe had given rise."

While the U.S. retains immense structural advantages, this historical context serves as a reminder that positions of power should not be taken for granted. Financial markets act as the ultimate arbiter in these scenarios; if political maneuvering goes too far, the bond market will likely signal the danger through spiking yields, effectively putting a ceiling on policy errors.

Bond Markets and Global Yields

Globally, we are seeing a dramatic shift in fixed income. Japan’s 30-year yields have rocketed higher, ending a decades-long period of stagnation. While vertical moves in yields are rarely "good," the context matters. Japan is attempting to reflate its economy, and a steepening yield curve is theoretically a sign of growth expectations.

In the U.S., the 30-year Treasury yield is also inching higher. There is a pervasive fear that rising yields will break the economy, yet every time they have risen recently, the economy has absorbed the impact. Unless yields spike violently past 5% in a short timeframe, the economy appears capable of handling a normalized rate environment.

The State of the Consumer and Real Estate

Despite pessimistic sentiment surveys, the hard data on the U.S. consumer remains robust. Bank of America data suggests that household balance sheets are in their best shape in decades. When viewing assets as a percentage of liabilities, consumers are in a stronger position today than they were in 1999—a period widely considered one of the greatest economic environments in history.

Correcting the Real Estate Narrative

There has been concern regarding rising delinquency rates in multifamily real estate. It is crucial to distinguish between the borrower and the renter in this data. The rise in delinquencies is largely occurring among property developers and owners who borrowed aggressively at floating rates and are now struggling to refinance, rather than renters failing to make monthly payments.

Furthermore, a massive demographic shift is on the horizon. Over the next decade, Gen X and Millennials are projected to inherit trillions of dollars in real estate assets. While this "Great Wealth Transfer" will be gradual, it represents a significant shifting of capital that could reshape housing market dynamics and consumption patterns for years to come.

Conclusion

We may be entering a period characterized by higher geopolitical volatility paired with strong economic fundamentals. The alignment of fiscal spending, monetary easing, and credit expansion suggests an administration intent on running the economy "hot."

For investors, the key is to distinguish between headline noise and earnings signals. If corporate earnings remain strong and GDP continues to grow, the market can likely digest political headlines and higher yields. The rotation into small caps and the resilience of the consumer suggest that the bull market has legs, even if the path forward is bumpier than before.