Barclays joins Morgan Stanley in questioning small-cap rally

Myth that smaller companies are better positioned to weather global trade war one reason cited for caution.

Two Wall Street strategists are casting doubt on one of this year’s most-popular trades: buy small-cap stocks.

Don’t be fooled by the consensus that smaller companies are better positioned to weather a global trade war, Barclays’ Maneesh Deshpande wrote in a note Monday. While it’s true that their domestic focus makes them less vulnerable to trade barriers, their bigger reliance on imports means they are susceptible to a deeper squeeze in profit margins, he added.

Over at Morgan Stanley, Mike Wilson advised investors to trim holdings in small-caps. The latest outperformance in dividend stocks such as utilities signals a reduction in risk appetite, a trend that’s likely to continue and bode ill for smaller firms, he said. The firm downgraded the group to equal weight from overweight.

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“While we have been expecting small caps to do better this year on faster relative earnings growth, much of this relative growth has been priced at this point,” Wilson wrote in a note Monday. “We’re also becoming concerned that small caps may be getting too much of a tailwind from the rising trade tensions.”

The Russell 2000 Index of small-caps has rallied 11 percent this year, almost triple the gain for the S&P 500, a large-cap benchmark that includes multinational firms. The small-cap gauge added 0.6 percent as of 2:40 p.m. in New York, trailing the market for the first time in five days.

(More: Some small-caps win in the long term — but which ones?)

To compare the trade impact for small versus large companies, it’s wrong to simply look at the proportion of sales from overseas, Deshpande said, because many multinational firms own foreign businesses that are not subject to tariffs.

Exports, the amount of goods shipped out of the U.S., is a better gauge, he said. Going by that measure, small companies still show a smaller exposure, but the gap to large caps is much smaller.

At the same time, the cost side of the equation puts small-caps at a bigger disadvantage. All considered, they end up being more vulnerable, according to a Barclays study.

(More: Top 10 small-cap funds this year)

“Paradoxically, small caps are more exposed to a trade war,” Deshpande wrote. “The outperformance of small cap versus large cap stocks since March is unjustified.”