The small caps disappoint | USAEMALL.com

Good morning. Walmart’s share price fell more than 6 per cent yesterday, after the retail giant warned that US consumers look set to step back this year. Despite record sales, its quarterly revenue fell short of Amazon’s for the first time, after successfully fending off the ecommerce rival for years. But Amazon and other retailers were also down on Walmart’s dour consumer outlook. Email me with your favourite Great Value and Amazon Basics products: aiden.reiter@ft.com.

Small caps

Any change of the political guard increases the odds that neglected parts of the market will finally get their due. Since Donald Trump took office, European and Chinese equities — unloved, underbought, and some would argue undervalued — have had their moments. But small caps, the forsaken stocks that were widely expected to get a boost from the president, have underperformed. Despite beating large caps and mid caps in the run-up and immediate aftermath of the election, small caps have erased most of their gains. Since inauguration day, there has been a reversal of fortunes:

There are many reasons to believe small caps will benefit from Trump’s policies. They are more sensitive to economic growth, and many analysts predict his policies will boost US output. Because small caps generate more of their revenues and profits domestically, they may remain insulated from the worst of tariffs, and potentially get a bigger boost from tax cuts. And looser M&A rules could make more small companies targets for acquisitions, giving small-cap stocks a special lustre.

A month into the Trump administration, none of these theories are dead. We still do not know where tariffs are headed, tax cuts remain in play, his policies could still boost growth, and M&A could pick up in earnest once his regulatory team is fully in place. But with all the uncertainty, investors are in a defensive crouch. From Jordan Irving at Glenmede:

It’s just glory deferred [for small caps], I guess. Because it is so unclear what will happen, [smaller] companies cannot take a confident stand, and investors stay embedded with what is working.

Neglected parts of the market broadly, and higher beta small caps specifically, are used as trades against the dominant market narrative. When no one knows what is going on, investors stick with what has worked. And, relative to large caps, small caps have not worked for some time. From Stephen DeNichilo at Federated Hermes:

It’s a continuation of a trend that we have seen over the past five years. The Russell 2000 is up over 30 per cent. The S&P 500 is up over 80 per cent. There is structural underperformance. Historically, when you have thought about innovation and animal spirits, it has been driven by small-cap stocks. Small-cap companies are more nimble, when there is risk-taking that is where the market goes. But what you have seen is the mega-cap companies is where [the most] innovation [and earnings growth] has taken place.

On balance, recent news has been slightly negative for small caps, too. As Unhedged has discussed before, the small cap “floating debt” argument — that they are more leveraged, often with floating rate debt, and are thus poised to do well as rates fall — is overplayed. But the Federal Reserve’s recent pause still hurts the smalls more than the bigs, given their more limited financing options. Also, though we still do not have the full picture of Trump’s economic priorities, the immigration policies he has put in action may harm growth.

Small caps could still get a Trump bump. But, given their outperformance relies on not one, but many of Trump’s promises, investors need to know more before that can happen.

The balance sheet and a sovereign wealth fund

Earlier this month, the Trump administration put out an executive order calling for the creation of a US sovereign wealth fund. As Unhedged wrote when this idea was first floated back in September, creating such a fund makes little sense for the US. To have a wealth fund you need wealth, specifically surplus wealth. The US runs a massive fiscal deficit, and what “wealth” we have is used to reduce it.

The Trump administration has seemed to take this under advisement. Rather than increase borrowing or diverting other government revenues, Treasury secretary Scott Bessent has said the administration will “monetise the asset side of the US balance sheet” to create the fund. The White House’s fact sheet refers to the “5.7tn dollars in assets” that the federal government holds. Here is a table summarising the line items on the US balance sheet:

At first glance, there is not a lot that can easily be monetised to make a sovereign wealth fund. The biggest piles of money are loans receivable and general property, plant, and equipment. The first bucket is money not currently in the government’s hands, and mostly loans at such low interest and with such high default that private counterparts would not want to buy them. Monetising the second pile is feasible, and maybe even likely if Elon Musk’s Doge gets rid of so many jobs that the government starts selling off buildings. But Trump, the real estate mogul, might be loath to sell off the US’s valuable properties, and the commercial real estate market is not exactly thriving.

One possibility is mortgage guarantors Fannie Mae and Freddie Mac; many analysts expect the Trump administration will end the government’s conservatorship of the two. But privatising them would be a complex process, and it bears risk for the housing and equity markets. Unhedged is also not quite sure how the government would capitalise on the privatisation. Would it get a profit by selling equity? Or potentially keep an equity stake and (ironically, perhaps) take a collateralised loan against it? Email with your suggestions.

It’s also possible for the US to use its gold. On the balance sheet, the nation’s gold reserves are priced using a statutory value of $42 an ounce and listed as $11bn; at today’s high market value, those US gold reserves are worth closer to $760bn. Some or all of that gold could be sold, or used as collateral to set up a fund. But doing so would enrage gold bugs, who would see gold fall from its record highs.

The government could use the Exchange Stabilization Fund (ESF, $210bn), a fund within “other monetary assets” initially intended to help stabilise and protect the dollar. Converting it for use in a sovereign wealth fund is somewhat tricky; most of the ESF is in the form of special drawing rights, or the supplementary monetary reserve asset issued by the IMF. From Stephen Paduano at the University of Oxford, formerly at the US Treasury:

The US would not be able to use its SDRs directly for sovereign wealth fund purposes. We can only channel SDRs to “prescribed holders” — other IMF members, regional central banks, and multilateral development banks. If you are President Trump and secretary Bessent, you could instruct the World Bank to issue SDR-denominated bonds and then purchase those bonds with the US’s spare SDRs, which would bring down the bank’s borrowing costs and give them more room to invest in their priorities. But it seems like they would not want to be constrained by the rules governing SDRs.

What they could do instead is swap Treasury SDRs for dollars with the Fed — through what are known as Special Drawing Right Certificates (SDRCs). SDRCs is already a common practice. When a partner country wants to exchange its SDRs for dollars, the Treasury will swap SDRCs for dollars with the Fed, and then sell dollars to the partner country in exchange for SDRs.

Still, using SDRCs is not particularly clean either, and there are a lot of rules governing the ESF that would make it hard to use those funds.

In sum, the Trump administration might be able to monetise the balance sheet to make a sovereign wealth fund. But it won’t be easy. And, unless they sell a lot of gold or land, the fund probably wouldn’t be very big, either.

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