When Donald Trump came to power, many people (including us) thought it may bring about a change in US financial markets. For more than a decade, investors had been in thrall to the mega-cap technology giants, but the economic boosterism and regulatory roll-back of the Trump era promised a better environment for domestically-focused companies – and smaller companies in particular.
Until the past week or so, the US technology trade had been gathering pace, with the CNBC Mag7 index up 18% for the year to date*. The S&P 500 Equal Weighted index – which gives equal priority to all the companies in the index rather than favouring the mega-caps – has trailed the standard S&P 500 index by almost 9% for the year to date**.
In the meantime, the small and mid-caps have struggled against a backdrop of higher-for-longer interest rates, tariffs and uncertain domestic economic growth. The benchmark Russell 2000 index is up just 5.3% for the year to date***. Good stock pickers have managed to defy this relatively gloomy environment, but it has been a tough backdrop.
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AI versus other?
The dilemma now for investors in the US is whether AI can continue to lead, and whether US markets can broaden out into other areas. The first question is the main preoccupation for investors today and the jury is still out. Maneesh Bajaj, manager on the Brown Advisory US Flexible Equity fund, explains the dilemma: “The pace and scale of AI-related investments are so extraordinary—and the commensurate revenues and profits so distant—that it may be humanly impossible to accurately determine the returns these investments will generate.”
His view is that it is “highly unlikely” that the enormous amount of capital pouring into AI infrastructure will deliver the high returns investors expect. “Perhaps this time truly is different, and Artificial Intelligence can provide a better answer to this puzzle than we can know.”
He doesn’t dispute the transformational potential of AI: “Many of our portfolio holdings are at the forefront of AI innovation and are investing at scale in this new technology.” The fund invests in Alphabet, Meta, Amazon and Microsoft, all of which have a stake in the AI revolution****. However, he says that valuations are now a cause for concern. There are also other signs of excess – companies borrowing to invest in AI, for example – that should put investors on alert.
Smaller companies revival?
This would suggest investors need to exercise at least some caution in their exposure to the AI trend and US mega-caps. US Smaller companies might be a natural balance. However, investors need to be sure that some of the problems that have beset this part of the market are over.
Hugh Grieves, manager of the Premier Miton US Opportunities fund, outlines some of the issues for the sector: “Shares of companies that are not exposed to the AI euphoria have struggled, both with investors’ attention as well as with the wider economic backdrop. The fallout from President Trump’s ‘Liberation Day’ tariff announcement and subsequent threats to global trade have reverberated throughout the economy.
“Businesses, faced with significant uncertainty as to supply chains, trade policy and end demand, have slowed or paused making investment and hiring decisions, which in turn has rippled through the economy. Consumers, listening to the media calling out the rising risk of an imminent recession, have responded by being more cautious and holding back on spending. The net result has been a quick shock to the economic nervous system.”
Nevertheless, it is possible that some of this uncertainty is being resolved. There is greater clarity on tariffs and trade policy, for example, and the US economy appears to have weathered the tariff storm reasonably well. Although the government shutdown has limited the flow of information, the most recent set of data shows the economy growing at an annual pace of almost 4%^.
Interest rates are falling, with the Federal Reserve cutting rates in two consecutive meetings. This should support economic growth, but also boost merger and acquisition activity, which in turn, tends to favour small and mid-cap companies.
There is also a valuation argument. While it is a stretch to say there are any bargains in the US market, the magnitude of underperformance for small caps versus large caps means there is more wiggle room. Matt Mahon, manager of the T. Rowe Price US Smaller Companies fund, says: “The dominance of AI-levered companies in the market, regardless of their future profitability potential, has led to a de-rating of the steady compounders that we favour. Despite these challenges, we have taken the opportunity to invest in companies with strong business models and durable growth capabilities that trade at highly attractive valuations.”
The group also says that the One Big Beautiful Bill Act delivered a major tax boost for small businesses via immediate research & development and capex deductions. “Deregulation offers another potential tailwind. The industrials, materials, and energy sectors, which are at the heart of the administration’s policy initiatives and feature more prominently in the US SMID universe, could be the biggest beneficiaries.”
They also see AI opportunities filtering down into the mid and small-cap arena. “The next phase could see smaller firms seizing opportunities to disrupt their industries through AI applications. Additionally, the long-term buildout of AI infrastructure provides a “picks and shovels” opportunity in the SMID space – think electrical equipment makers, heating and cooling specialists, and niche manufacturers.” However, investors need to remain vigilant about tariff risks and the US economic outlook.
US equities are a tough call at the moment. AI is a once-in-a-generation shift, but there is a question on the price investors are being asked to pay to participate. The smaller end of the market looks ripe for a revival, but there are lingering concerns on tariffs and the strength of the US economy. We believe it is an environment to put capital with careful active managers.
