Tariffs weigh on small caps, investors ponder next moves

For the sixth month now, U.S. President Trump has been waging a zigzagging trade war. Since “Emancipation Day” on April 2, when he announced the largest tariffs in nearly a century, several countries, including the UK and Japan, along with the EU, have already managed to get a deal done to reduce the new tariffs. On August 11, Trump temporarily delayed the introduction of tariffs on Chinese goods. During this period, shares of large companies climbed to new highs, while the weakness of small-cap stocks became more apparent.

Why higher tariffs hurt small-cap companies more than their larger rivals, and what course investors should take in this environment, is the focus of this Oninvest piece.

In the first seven months of the year, the S&P 500 has risen almost 20%, while the index made 10 new all-time highs in the month of July, JPMorgan points out in a market update.

Small-cap indexes, meanwhile, are underperforming this year, with the S&P SmallCap 600 up just 0.8% year to date as of August 18 and the Russell 2000 up 2.9%.

This disparity between large and small caps became more pronounced as tariff concerns grew in mid-February, with small caps facing a steeper decline in April (minus 21%) compared to large caps (minus 14%) during the height of tariff fears, JPMorgan wrote.

Small caps typically tend to fall faster and deeper than the broader stock market as recessions approach, Bloomberg notes. On the other hand, they are usually the first to rebound on the way out of a downturn, which makes them a "useful predictor in times of turmoil."

However, as traders reassessed the impacts of the new trade regime along with signs of slowing economic growth, stubborn inflation, and still-high interest rates, the outlook for small-caps "muddied rapidly." The tariffs, though they are less than Trump laid out in April, make matters even worse.

Small companies tend to have lower profit margins in aggregate (about 6.5% versus about 13.0% for large caps) and are more leveraged (current net-debt to earnings before EBITDA of roughly 3.7 versus 1.3 for large caps), JPMorgan writes.

Supply chains and China tariffs

Unlike large corporations, small businesses typically rely on a much narrower supplier base, notes Alyona Nikolaeva, portfolio manager at Astero Falcon.

As JPMorgan points out, 94% of firms with 1-19 employees import from just 1-4 countries, while close to 60% of firms with 500+ employees import from 5 or more countries. 

At the same time, China is typically the main import channel for small businesses, Nikolaeva explains. With China’s status as the “factory of the world,” it’s logical for these importers to source primarily from there (at least in the beginning), JPMorgan argues. But it is precisely imports from China that have been “hit hardest,” Nikolaeva adds. This reliance on China means smaller businesses may face higher tariff rates, depending on where trade negotiations settle. Currently, the average effective tariff rate on China is close to 50%, significantly higher than most other major trading partners, JPMorgan calculated.  

By contrast, larger companies enjoy broader and more flexible supply and logistics networks, allowing them to redirect imports to other jurisdictions much more quickly, Nikolaeva observes.

Pricing power

When tariffs go up, businesses face a choice: absorb the additional costs in their margins or pass them on to consumers, Nikolaeva notes. A recent survey conducted by the Atlanta Fed and cited by JPMorgan indicates that smaller companies have a lower expected pass-through rate to consumers than larger firms. Small businesses expect to cover about 54% of increased tariff costs through 2025 price increases, compared to 65% for larger firms.

“Small companies often lack strong brand recognition and a loyal customer base. Their marketing budgets are limited, and suppliers tend to be less accommodating. As a result, it is much harder for them to pass higher costs on to consumers,” says Nikolaeva of Astero Falcon. She adds that in a rapidly changing environment, it is difficult for these firms to adapt quickly to external shocks, which is why import tariffs hit them first.

Still, the pricing challenge for small companies may be more subjective, argues Alexandr Orlov, managing director at Arbat Capital. “Small firms often think small: they assume they cannot raise prices because they will lose market share. But tariffs apply to everyone, and competitors will also be forced to raise prices,” Orlov explains.

Despite the advantages of Trump’s Big, Beautiful tax bill, which in theory should support companies of all sizes, JPMorgan recommends large caps for a short time horizon. Astero Falcon takes a similar view. “In this environment, it makes sense for investors to stay with larger, more transparent businesses that combine high margins, adaptability, established logistics networks and proven market strength,” says Nikolaeva.

Orlov advises buying shares of the strongest players in mass-market consumer goods. According to Zacks, candidates include Procter & Gamble, Colgate-Palmolive, Church & Dwight, and Grocery Outlet Holding. At the same time, Orlov recommends a short position in the Russell 2000 index.

Arbat Capital also suggests buying Treasury Inflation-Protected Securities (TIPS). Such instruments shield investors’ capital from depreciation at times of elevated inflation, which Orlov believes will persist.

The AI translation of this story was reviewed by a human editor.