US small caps: What’s in store for 2025?

Key takeaways:

1. Volatility as opportunity: Increased volatility in 2025 is seen as an opportunity rather than a threat. 
2. Consumer durables: Companies in the consumer durables sector producing big-ticket items, such as RVs and boats, may see a revival in demand.
3. Middle- and lower-income spending: A potential increase in spending among middle and lower-income consumers is expected.
4. Natural gas demand: The demand for natural gas is projected to grow significantly due to increased power needs.

As we look ahead to 2025, Royce Investment Partners' portfolio managers were interviewed on what might be next for US small caps. Co-Chief Investment Officer Francis Gannon, along with Portfolio Managers Lauren Romeo, Miles Lewis, and Brendan Hartman, provide their perspectives on the market dynamics and opportunities.

Volatility as opportunity

Francis Gannon emphasizes that while 2024 has been relatively calm, 2025 is expected to bring more typical levels of volatility. However, Gannon views this increased volatility as an opportunity rather than a threat. "We do not look at increased volatility through the conventional lens of fear but through the longer-range vista of opportunity," Gannon explains.

Historical data supports this view, showing that periods of heightened volatility often lead to higher-than-average returns for small-caps.

Consumer durables sector

Lauren Romeo highlights the potential for a rebound in the consumer durables sector. Companies producing big-ticket items like RVs and boats have faced challenges due to shifts in consumer spending post-pandemic. However, Romeo believes that demand has hit a bottom and could revive in 2025, driven by factors such as pro-growth economic policies and the nearing replacement cycle for products sold during the pandemic.

Romeo said, "After many of these companies benefited from a significant boost in demand during the pandemic, sales in several industries have slumped due to the post-pandemic reallocation of discretionary spending by consumers from products to services (e.g., travel and entertainment), along with the persistence of higher interest rates stemming back to 2022 when the Federal Reserve was working to reduce inflation."

In response, big-ticket consumer durable products manufacturers and their dealers have been reducing inventory over the past 18 months and implementing cost reductions. Based on conversations with the management teams of some affected companies, as well as related players across their industry supply chains, demand appears to have hit a bottom.

The removal of the US election overhang and several pro-growth economic policies espoused by the incoming Trump administration, such as deregulation, reshoring, and extending or expanding individual and corporate tax cuts, may provide the required boost to consumer confidence that, assuming inflation is contained, could be the catalysts that unlock deferred big-ticket consumer spending.

Additionally, products such as RVs and powerboats that were sold during the pandemic are nearing the five-year ownership mark, which is often when owners seek to replace or upgrade to a new unit. Moreover, the size of the potential upgrade fleet is larger than it has been historically because the pandemic drove a higher-than-normal influx of first-time buyers who were new to the activity.

Companies that are both dominant suppliers to the major brands and have significant potential earnings leverage from improved factory utilization and/or permanent cost actions taken during the downturn appear poised to benefit if end market demand revives during 2025.

Middle- and lower-income spending

Miles Lewis points to a potential increase in spending among middle and lower-income consumers. These groups have been hardest hit by inflation and higher interest rates, but improvements in gas prices, food prices, and housing costs, along with gains in real income, could lead to a shift in spending patterns in 2025.

Lewis explains, "We think 2025 could mark a shift in spending for the bottom half of the population. While the impacts of inflation have been well documented, we think certain areas matter more than others, and each is continuing to show improvement: gas prices have come down to 2021 levels—well below the peaks of 2022 and sustained high levels in 2023—and are expected to continue when the new administration takes office."

Similarly, the rate of increase in food prices has come down considerably, up only 2.4% per the most recent data, compared to a peak of more than 11% in 2022. Various food packaging companies report that their customers (consumer packaged food companies) are focused on driving volumes via lower pricing after relying on price to drive revenues for several years, which supports continued improvements on price for middle- and lower-income consumers.

Housing costs also continue to come down and are likely to continue falling given the lagged effects of government data versus real-time indicators. Against this improving backdrop are continued gains in real income for US consumers.

These gains have picked up additional steam in recent months in a favorable climate of low unemployment, lower interest rates, improving consumer and small business confidence, and stable credit card delinquencies, which were down slightly in 3Q24 versus 2Q24.

Natural gas demand

Brendan Hartman is looking at the growing demand for natural gas, driven by the need for new power generation capacity, and sees opportunities. Investments in data centers, advanced manufacturing, and electrification are expected to drive a 3% annual growth in peak power demand over the next five years. Natural gas, with its abundant reserves in the US and faster commissioning times, is well-positioned to meet this demand.

Hartman notes, "Power demand is accelerating in the US after two decades of less than 1% annualized growth for natural gas. Based on official forecasts from the North American Electric Reliability Corporation, the Federal Energy Regulatory Commission and state level forecasters, demand for peak power is expected to grow 3% a year over the next five years.”

Driving this rapid rise in demand are concurrent significant investments in the data centers needed for the ongoing evolution in artificial intelligence, advanced manufacturing for domestic semiconductor production, and the electrification needed to generate increased levels of energy.

And while 3% annualized demand growth might sound small, it means a significant need for new energy generation and transmission capacity. Currently, there is a scramble to find faster sources of power generation because it can take up to four years to bring new generation online.

Natural gas has therefore emerged as a favored way to meet the power demand, driven by abundant US natural gas reserves and the availability of portable natural gas-based generators and small gas turbines, which are much faster to commission compared to other forms of power generation.

Large capacity stationary gas turbines, nuclear reactors, and solar plants, despite their favorable economics, are hamstrung by permitting delays and administrative bottlenecks around grid connectivity.

Volatility and market dynamics

Francis Gannon touches on the interesting dynamics of the US equity market in 2024, particularly for small caps in the second half of the year. The relative dearth of volatility has been even more pronounced with large-cap stocks, as measured by the VIX—the CBOE Volatility Index, which tracks the market’s expectations for the relative strength of near-term price changes in the S&P 500 Index (“SPX”).

Often referred to as “the fear index,” the VIX is derived from the prices of SPX options with near-term expiration dates and generates a 30-day forward projection of volatility, a gauge of the speed with which share prices change.

Within small cap, the percentage of trading days with moves of 1% or more in the Russell 2000 Index has been marginally lower in 2024, another sign of reduced volatility. The small-cap index’s average over the last 25 years has been 42% of days with such moves. Year-to-date through December 11, 2024, the Russell had 41%, or 98 out of 239 days, with moves of 1% or more.

Gannon added, "Our more than five decades of small-cap investing tell us that this state of affairs, while more than welcome, will end regardless of asset class. We not only expect more historically typical levels of volatility in 2025 but also think it’s important to remind our investors that we do not look at increased volatility through the conventional lens of fear but through the longer-range vista of opportunity. As risk-averse and price-sensitive long-term investors, we always work to use short-term volatility to our long-term advantage".

In addition, history shows that periods of heightened volatility were followed by higher-than-average small-cap returns. Royce Investment Partners looked at subsequent average annualized returns for the Russell 2000 and the large-cap Russell 1000 following periods when the VIX was elevated, using monthly rolling return ranges for the volatility index.

We found that the percentage of periods when the Russell 2000 had higher average annualized 3-year returns than the Russell 1000 were at their highest following periods of heightened volatility. Coupled with small-cap’s impressive absolute and relative strength in the second half of 2024, we are cautiously bullish as we look toward 2025.