In January 2025, at the dawn of Donald Trump's second term in office, the financial markets find themselves at a delicate crossroads, caught between the memory of the major reforms initiated during his first stint in the White House and the new measures announced to stimulate economic growth. Investors are now scrutinising the potential effects of this new programme on the relationship between large caps and small caps. In recent years, small caps have lost the yield premium that was long considered their hallmark.

‘Small cap premium’ under pressure since 2020

Historically, small caps have offered a performance premium over large caps, a "small cap premium" firmly anchored in the minds of institutional and individual investors ^[1]. Between 1926 and 2020, they produced an average annual return of 11.9%, compared with 10.3% for large caps ^[2]. This 1.6 percentage point premium justified additional risk-taking, which was synonymous with access to stronger domestic growth, the ability to adapt more quickly and responsiveness to local fiscal stimuli.

From 2020 onwards, this dynamic has been reversed. Bloomberg figures show that between January 2020 and December 2023, the S&P 500 (representing large caps) rose by 54%, while the Russell 2000 (the flagship index for small caps) gained just 29%. There are many reasons for this: the rise of the technology sectors, the increased concentration of stock market leadership in a few large stocks, and the tightening of credit conditions, which has a negative impact on more fragile structures. In 2024, this imbalance persisted, reinforced by the rise of the technology giants (the 'Magnificent 7'), whose higher valuation multiples reflected investors' enthusiasm for the growth sectors of innovation, artificial intelligence and the digital economy.

Trump 2025: double-edged reforms

The election of Trump to a second term in office now raises two major questions. The first is the effect of the new tax reform on small businesses. The president-elect is proposing ^[1] to cut the corporate tax rate from 21% to 15%, continuing the effort begun by the Tax Cuts and Jobs Act (TCJA) of 2017. According to analyses by Morgan Stanley and RBC ^[2], such a cut could boost the net profits of small caps by between 10% and 18%. This is a significant gain, greater than that expected for large companies that are already massively internationalised.

Historically, the TCJA has given a boost to small caps, with the Russell 2000 outperforming the S&P 500 in the first few months following its enactment. The argument is that small companies, which are mainly focused on the domestic market, benefit more directly from national tax breaks, boosting their competitiveness against large caps.

The second issue concerns trade policy. Trump, in line with his "America First" policy, plans to extend tariffs to 20% on all imported goods. In this way, he hopes to relocate production lines, particularly in the manufacturing industry, and stimulate employment on American soil. The challenge for small caps lies in the fact that they are still largely dependent on imported raw materials and components. According to the US Small Business Administration (SBA) ^[1], in 2021, US small businesses accounted for almost 41% of Chinese imports into the US as a whole. Higher tariffs could increase their costs and wipe out some of the expected tax gains. An academic study published in the Journal of Economic Perspectives ^[2], carried out during the 2018 trade war, has already shown that tariffs at the time were almost entirely reflected in US domestic prices.

In 2025, when supply chains remain fragile, such pressure on costs could limit the tax advantage and keep the valuation of small caps at low levels. The scenario is not unequivocal: certain industries that benefit from protectionism, such as local suppliers of basic materials or specialist industrial service providers, could benefit from an influx of domestic orders, especially if large companies choose to abandon certain less profitable production lines in favour of more responsive subcontractors. But uncertainty remains, as rising import costs will apply indiscriminately, penalising both niche innovators and more traditional players.

New market disparities

The stock market scene in 2025 will also be characterised by sectoral disparities. Large caps, particularly in technology, will retain significant momentum. In 2024, the major technology stocks in the S&P 500 posted average growth of 35%, according to Bloomberg, compared with 8% for small caps in the industrial sector. This disparity in performance is due to the more solid financial base of the digital giants, which are able to invest massively in innovation, particularly in artificial intelligence and cybersecurity. Many small caps, lacking significant resources, struggle to compete in these areas.

The monetary policy environment also needs to be watched carefully: if the Federal Reserve only cuts interest rates to a limited extent, the high cost of capital will remain a brake. Smaller companies, which are often more heavily indebted, pay a high price for this financial vulnerability, while larger companies retain privileged access to financing and greater strategic leeway. What's more, a growing number of small businesses have adopted "pass-through" tax status, whereby the company's income is taxed directly in the owner's individual tax base ^[3]. This would therefore limit the positive impact of a reduction in corporation tax.

Lastly, almost 40% of Russell 2000 companies reported negative net results in the last quarter. Admittedly, their high levels of capex are weighing on their net profitability, but the segment remains less resilient and riskier than the largest capitalisations.

As a result, investors are reluctant to commit to smaller stocks, fearing that the impact of tax reforms will be neutralised by higher production costs and a reduced ability to cope with economic or regulatory shocks.

A selective approach

Participants seeking returns will need to be discerning, adopting a selective approach. It is not simply a question of betting on small caps catching up across the board, but of identifying those that will be able to take advantage of the reorganised tax environment, contain their costs in a context of high tariffs and respond to the new demands of the domestic market. Donald Trump's second term in office in no way guarantees the return of the historic premium, but it does provide a political, economic and financial laboratory from which some fine growth stories could emerge. If the Russell 2000 manages to regain some of its dynamism, it will be at the price of rapid adaptation, enlightened strategic choices and greater resilience to external shocks.

Jérôme Gazel is a portfolio manager at Edmond de Rothschild Europe

Sources

^[1] “” published by the US Small Business Administration

^[2] “” in “The Journal of Economic Perspectives” by Mary Amiti, Stephen J. Redding, and David E. Weinstein

^[3] “” published by the Washington Center for Equitable Growth

^[4] “” published by the Tax Foundation

^[5] Morgan Stanley Research (2017): “US Equity Strategy: The Impact of Corporate Tax Cuts on Small Caps” & RBC Capital Markets (2019-2020): “Small Caps: Potential Winners from a Further Corporate Tax Rate Cut”