BNP Paribas strategists: 'Market beginning to price in lower geopolitical risk'
There are a number of tailwinds for small caps that could reemerge, including Fed rate cuts, healthy M&A pipelines, improving industrial activity, and strong domestic capex, says BNP Paribas / Photo: Facebook/NYSE
The first quarter showed that investors have begun actively rotating capital into small caps. Against a backdrop of lower interest rates and a search for undervalued assets, the smid-cap Russell 2000 significantly outperformed the broad-market S&P 500 index. Strategists from BNP Paribas Asset Management discussed in a podcast which fundamental factors supported the rally in small caps in the first quarter, why the AI boom is spreading beyond Big Tech, and what makes healthcare and software stocks attractive.
YTD performance
Since the start of the year, the Russell 2000 index has risen about 15%, while the S&P 500 has gained roughly 8%. According to Geoff Dailey, head of U.S. equities at BNP Paribas, despite the Russell 2000 plunging 10% amid rising geopolitical tensions and an energy crisis, markets had stabilized by the end of March: “clearly policy and inflation implications are still fluid at this stage, but the market is beginning to price in lower geopolitical risk,” Dailey said.
Below are the main reasons given for the small-cap rally in the first quarter.
Improving U.S. macro backdrop: investors saw signs of a manufacturing recovery, resilient consumer demand, and easing inflation. That boosted interest in more cyclical small-cap companies.
Expectations for Fed easing: the market began pricing in the possibility of rate cuts, which traditionally support small caps because they are more dependent on borrowing costs and the domestic U.S. economy.
AI infrastructure boom: rising capex by the largest tech companies supported semiconductor manufacturers, equipment makers, construction firms, and power companies, many of which fall into the small-cap segment. At the same time, the performance gap between infrastructure companies and software developers was significant. The iShares Semiconductor ETF gained more than 50%, while the iShares Expanded Tech-Software Sector ETF fell nearly 20%, Dailey noted.
Renewed focus on fundamentals: after volatility caused by the conflict in the Middle East, investors refocused on earnings, order volumes, and business quality.
Resilience by small-cap banks: concerns surrounding private credit risks and the software sector did not materially affect them because small-cap banks have limited exposure to those segments.
Outlook
Small caps continue to have solid upside due to several factors, according to Daniel Morris, chief market strategist at BNP Paribas.
BNP Paribas expects support for small caps to continue provided tensions in the Middle East continue to ease. Potential growth drivers for smaller companies remain Fed rate cuts, improving industrial activity, rising domestic investment in the U.S., and stronger M&A activity. According to Dailey, the market is now pricing in a more dovish monetary policy stance than before: “a flip by the Fed could easily add more rate cuts to the picture, providing another tailwind to small caps.”
BNP Paribas sees the most attractive opportunities in small- and mid-cap banks, early-cycle industrial companies, cybersecurity, and select software companies capable of adapting to the development of agentic AI. “Small-cap banks have low single-digit to zero exposure to non-depository financial lending,” Dailey said. “In addition, small-cap banks are generally under allocated to software lending.”
BNP sees valuation risk in AI infrastructure following the sharp rally, while some software and healthcare companies already look undervalued after the selloff earlier this year. Dailey said conditions in those segments should eventually improve. Given the strong fundamentals, he expects the sector to become attractive for takeovers at premium valuations.
