Is the Outperformance of DM ex US Small Caps a Lasting Trend?

Yes. In our view, developed markets (DM) ex US small-cap stocks are well positioned to continue outpacing their larger-cap counterparts. We expect this trend to persist due to three key factors: reduced sensitivity to global tariff changes, attractive relative valuations, and improving international economic fundamentals—including supportive policy and currency trends. For investors seeking to capitalize on these market dynamics, we advocate maintaining or adopting a modest portfolio tilt toward DM ex US small caps relative to DM ex US large caps.

Since early March, DM small-cap stocks outside the United States have delivered strong performance, coinciding with the introduction of new US tariff policies and heightened global trade tensions. The MSCI World ex US Small-Cap Index has returned 23.6% in US dollar terms since March 3, outpacing large caps by 9.6 percentage points (ppts). The greatest contributors to this rally have been the materials, financials, and industrials sectors, which tend to be more domestically or regionally focused and, therefore, less directly exposed to global trade disruptions.

The current global trade environment has been a key catalyst for this outperformance. DM ex US small-cap companies are less vulnerable to the effects of tariffs and trade volatility than their larger, multinational peers, whose operations and earnings are more directly impacted by shifts in trade policy. For example, large DM ex US consumer discretionary and information technology companies have delivered weak performance amid tariff-related uncertainty compared to their smaller-cap counterparts, which are more reliant on local demand and less exposed to cross-border regulatory changes. Multinationals with substantial US dollar revenue may face headwinds if, as we anticipate, the dollar weakens, since this would reduce the profitability of their overseas operations. Notably, DM ex US mid-/large-cap companies derive approximately 22% of their revenue from the United States, compared to just 11% for small-cap companies. As these dynamics persist, we expect small caps to outperform.

Valuations for DM ex US small caps also remain compelling. Currently, these stocks trade at a 10% discount to their mid- and large-cap peers based on normalized earnings ratios. While this discount has narrowed from a trough of 15%, it remains notable, especially since small caps have typically traded at a 16% premium since 1999. This valuation gap suggests that small caps are still attractively priced relative to larger companies, offering investors room for multiple expansion as market conditions improve. Analysts also expect DM ex US small caps to deliver robust EPS growth—12% in 2025 and 17% in 2026—compared to -1% and 10% for large caps, respectively. Although non-US small caps have lagged over the past five years, their long-term compounded returns have exceeded those of large caps by about 3 ppts annually over the last 25 years. This historical outperformance underscores the potential for small caps to deliver superior returns over longer investment horizons, particularly when entry points are favorable.

Looking ahead, international economic growth is expected to improve over the next few years, providing a favorable backdrop for small-cap equities, which tend to be more sensitive to changes in economic growth. Evolving policy dynamics in regions such as Europe and Asia may provide additional tailwinds. For example, Germany’s recent relaxation of its fiscal constraints and the establishment of a defense fund, as well as Japan’s efforts to reshore manufacturing, are likely to stimulate local economies. DM ex US small-cap indexes are heavily weighted toward industrials and materials—sectors that stand to benefit from increased government investment in infrastructure and protectionist trade policies.

In summary, we recommend investors maintain or adopt tactical exposure to DM ex US small-cap stocks from DM ex US large caps. Their relative insulation from trade disruptions, combined with attractive valuations and improving international economic fundamentals, positions them well for continued outperformance. The market structure of the DM ex US small-cap universe also presents unique opportunities, as this segment is often less efficient than the larger-cap space due to lower analyst coverage, limited institutional ownership, and greater return dispersion. These inefficiencies create opportunities for skilled active managers to identify mispriced securities and generate additional value add beyond that provided by a simple tilt to the market.