By Erik Norland
When the pandemic first struck, the Russell 2000 index of small-cap stocks underperformed the S&P 500® by nearly 20%. Investors appeared to view the companies of the Russell 2000 as being more negatively impacted by the lockdowns and more closely tied to U.S. economic conditions than their larger peers. The underperformance coincided with a plunge in inflation expectations.
Since equities bounced back from their lows in March, the Russell 2000 has outperformed the S&P 500 by 33%, lifting the ratio of the two indexes to its highest point since May 2019. The relative outperformance of small-cap stocks coincided with a sharp rise in inflation expectations, as measured by the difference in yields on nominal U.S. Treasury 10Y Notes and 10Y Treasury Inflation Protected Securities (TIPS), from a March low of 0.5% to a recent high of 2.1% (Figure 1).
That the performance of small-cap versus large-cap stocks would track inflation expectations is not a new phenomenon. Since 2010, small-cap stocks have outperformed large caps during periods of rising inflation expectations and vice versa. 2020 was no exception.
Looking further back -- the Russell 2000’s data history begins in 1979 – the performance of small and large-cap stocks have roughly been similar (Figure 2). However, their ratio has had extremely large moves, at times tracking certain phases of the economic cycle:
- Small caps have outperformed during periods of economic turbulence and during the early stages of economic expansion.
- Large caps have outperformed in the later stages of economic expansions.
Since the Russell 2000 data history began in 1979, there have been three previous periods when small-cap stocks outperformed:
January 1979 – July 1983: The Russell 2000 outperformed the S&P 500 by 77%. During this time, inflation rose to as high as 13% and the economy suffered a double-dip recession in 1980 and 1981-82 before staging an extremely strong recovery in 1983 with growth rates as high as 8.5%.
November 1990 – March 1994: The Russell 2000 outperformed the S&P 500 by 50% as the U.S. economy experienced a recession in 1990-91 around the time of the Gulf War and then had a slow “jobless” recovery.
March 1999 – March 2011: Small caps outperformed large caps by 116% as the U.S. economy experienced the “tech wreck” recession in 2001, as well as the global financial crisis in 2007-09 and its aftermath. Within this timeline, there was a brief period in late 2006 and 2007 (towards the end of the expansion that began in 2003) when large caps outperformed. Large-cap outperformance during the later stages of economic expansions has been common over the past four decades (Figure 3):
- July 1983 – October 1990: As the economic expansion of the 1980s continued, the S&P 500 outperformed the Russell 2000 by 92%.
- March 1994 – March 1999: During the last five years of the 1990s economic expansion, large-cap stocks outperformed small caps by 94%.
- March 2014 – March 2020: During the later years of the economic expansion in the 2010s, including the first few months of the pandemic, the S&P 500 outperformed the Russell 2000 by 56%.
Going forward, the outlook for inflation expectations is unclear. While they have risen substantially from their lows in March, inflation expectations at 2.1% over the next 10 years are not especially high by historical standards. That said, a tight labor market might be a prerequisite for durably higher inflation. Now, with the labor market still significantly disrupted by the pandemic, a demand for higher wages in the U.S. or elsewhere would seem unlikely. However, large budget deficits and continued central bank quantitative easing could help to elevate inflation down the road.
As far as the economic cycle goes, during the expansions in the 1990s and 2010s small caps continued to outperform for several years. The same was true during the expansion from 2003 to 2007, when small caps outperformed until the last year of growth. Although smaller U.S. firms were hard hit by the initial lockdowns in March 2020, investors seem to be much more optimistic about their prospects as we begin 2021, despite the continuing impact of the pandemic. Indeed, the Russell 2000 got a much bigger boost from news of the vaccines than did the S&P 500 (Figure 4). It may also be that investors see small-cap firms as being, on the whole, nimbler and more adaptable than their large-cap peers.
- Russell 2000 has outperformed during periods of rising inflation expectations.
- Small caps have outperformed during economic downturns and early stages of economic expansions.
- Small caps rallied more than large caps following news of COVID-19 vaccines.
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