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Small Caps Set New Highs, Outpacing Their Multinational Peers

Akane Otani

Shares of small U.S. companies climbed to a fresh record Wednesday, reflecting their gains in the recent tax overhaul and signs that U.S. growth once again looks more robust than that from overseas.

The rally marks a remarkable rebound for small caps, which fell behind large stocks last year as investors poured money into multinational companies they felt were best positioned to benefit from a synchronized pickup in the global economy.

Yet in recent weeks, data have suggested that momentum around the world could be faltering. Growth in the eurozone appears to have slowed in the first quarter of the year, while data Tuesday showed Japan’s economy contracted over the same period, ending the country’s longest growth streak in 28 years.

The comparatively rosier outlook for the U.S. has drummed up fresh optimism among investors in small caps—especially with many expecting small companies, which tend to pay higher effective tax rates than multinationals, to get a boost from corporate tax cuts.

The Russell 2000 index of smaller U.S. companies rose 1% Wednesday to 1616.37, topping its Jan. 23 closing high. For the year, the index is now up 5.3%, outperforming both the S&P 500, which has risen 1.8%, and the Dow Jones Industrial Average, which is up 0.2%. Those indexes are still more than 5% below their January highs.

“When you have an environment where we’re deregulating as opposed to increasing regulations and we’re reducing taxes, [small business] managers are going to feel more confident,” said Randy Gwirtzman, a co-manager of Baron Discovery Fund, a $226 million fund that focuses on small-cap companies. “We really think this environment can continue, and valuations for companies aren’t out of the ordinary in terms of being overly expensive.”

Smaller publicly traded companies broke away from the broader market in March and pushed higher, even as bouts of volatility related to fears of protectionist trade policies and missteps by technology companies caused the S&P 500 to slide.

One reason why small caps withstood the turmoil: Investors have bet that continuing skirmishes over trade policy between the U.S. and China, among other nations, are less likely to dent profits among domestic firms. The S&P 500 gets about 30% of its revenue from outside the U.S., compared with 21% for the Russell 2000, according to a Bank of America Merrill Lynch research note last month.

“When you think about what’s going on with trade and tariffs, small caps tend to be much more domestically oriented, so they would be less affected,” said Sameer Samana, global equity and technical strategist at Wells Fargo Investment Institute.

The recent divergence in growth outlooks between the U.S. and the rest of the world has also contributed to the rally in small caps, whose fortunes are more closely tied than multinationals to fluctuations in the U.S. economy.

Broad measures of the U.S. economy continue to show signs of expansion, with Commerce Department data on Tuesday showing Americans ramped up spending at the start of the spring despite a run-up in gasoline prices. Signs of strength among consumers have boosted the fortunes of smaller businesses, especially given household spending accounts for more than two-thirds of U.S. economic output.

“Middle-income consumers are finally starting to spend at rates we would expect in an economic recovery,” Gregory Trojan, chief executive of BJ’s Restaurants Inc. said on the firm’s April earnings call. “This is helping improve restaurant traffic everywhere, and we are a key beneficiary.” BJ’s shares are 44% higher for the year.

A measure of confidence among small-business owners edged up in April to remain near records, buoyed by optimism around consumer spending, lower taxes and strong earnings, according to a survey from the conservative-leaning National Federation of Independent Business.

“Consumers are confident in the U.S. economy, and tax reform has added a layer of optimism this year: Consumers were more prevalent at boat shows and they were not lookers, they were buyers,” Jack Springer, chief executive of Malibu Boats Inc., said on the company’s May earnings call. Shares of Malibu Boats are up 47% for the year.

Not all analysts are convinced that small caps can sustain their rally. With investors becoming increasingly bullish, small caps could run in danger of becoming a crowded trade, something that outperforms the broader market until it suffers a sudden reversal.

The Russell 2000 had rallied after the Nov. 8, 2016, election and in the period leading to the passage of the tax cuts late last year, only to give up its gains as investors moved back into the stocks of fast-growing multinational companies, especially those in the technology sector.

Small-cap-focused funds saw some of their biggest monthly inflows in years in late 2016 and early 2017, only to then suffer 14 straight months of outflows through April, according to Morningstar Inc. data.

Any signs of a slowdown in the U.S. economy, which has appeared to gather momentum following a slow start to the year, could once again lift multinationals past their smaller peers, analysts say.

But for now, many are feeling optimistic, citing the tailwinds from tax cuts and stronger consumer spending.

Outflows among small-cap funds appear to be easing, too, with redemptions totaling just $128.4 million in April, the weakest in more than a year, after investors put nearly $770 million into growth-focused small-cap funds, according to Morningstar.

“Small caps will basically go as the economy goes,” said Wells Fargo’s Mr. Samana.

Write to Akane Otani at akane.otani@wsj.com and Michael Wursthorn at Michael.Wursthorn@wsj.com



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