The case for international small-cap stocks

U.S. small-cap stocks are attractively valued but face challenges from high interest rates and a slow economy. One alternative is for investors to seek small-cap exposure outside the U.S., where numerous tailwinds appear to be aligning.

The U.S. stock market has become broadly expensive, with one major exception—small-cap stocks. Even after an uptick in valuations over the past three years, small caps are still priced below their longer-term averages.

Meanwhile, the difference between large-cap and small-cap valuations has become extreme. As of late July, the forward P/E for the S&P 600 Index—a widely followed U.S. small-cap benchmark—was more than seven multiples below the P/E for the S&P 500 Index.

This is not just a U.S. phenomenon. In fact, international small-cap stocks are even cheaper: As of late July, the MSCI All Country World ex U.S. Small Cap Index was priced at only 14.49 times forward earnings, slightly below the 15.02 P/E for the S&P 600.

One of the biggest challenges U.S. small caps face right now is the high level of interest rates.

After more than a decade of low or even near-zero rates, many small companies have become somewhat dependent on financing their operations using low-cost debt.

But stubborn inflationary pressures have forced the U.S. Federal Reserve to keep interest rates elevated for an extended period, creating a difficult operating environment for U.S. small caps.

Interest rates pose much less of a challenge for international small-cap stocks. This is because non-U.S. small-cap companies tend to hold significantly less debt than their U.S. counterparts.

And interest rates are quite a bit lower in most other countries—most notably in the eurozone and Japan.

Another headwind for U.S. small caps has been a relatively sluggish U.S. economy. After achieving a “soft landing” in 2023, the U.S. economy has remained soft outside of a few specific areas, such as the boom in artificial intelligence spending.

Growth expectations outside the U.S. also have been somewhat soft . . . until recently. But the German government’s March decision to lift its so-called “debt brake”—which is a borrowing restriction in place since 2009—has created a sharp pivot in economic expectations for Europe. More than a decade of fiscal austerity in the eurozone appears to be coming to an end.

Meanwhile, growth expectations in China also have improved considerably due to an uptick in both monetary and fiscal stimulus.

The bottom line is that numerous tailwinds appear to be aligning behind international small-cap stocks. In addition to lower interest rates and increased fiscal stimulus, non-U.S. small caps are benefiting from an improving mergers and acquisitions environment. Promising start-ups outside the U.S. are also less likely to be snapped up by venture capital firms, expanding the small-cap opportunity set for public investors.

As a result, international small caps have outpaced the U.S. large-cap market so far in 2025. Through July 22, the MSCI All Country World ex U.S. Small Cap Index returned 12.22% versus only 7.99% for the S&P 500.

This performance advantage has been even larger for U.S.-based investors, thanks to U.S. dollar weakness against most major currencies. A weaker dollar has tended to enhance the value of assets—and earnings—that are priced in foreign currencies. In U.S. dollar terms, international small caps returned more than 20% for the year through July 22nd.

We think that continued dollar devaluation is a distinct possibility. After nearly 15 years of strong appreciation, the U.S. currency is still expensive, despite recent weakness. Elevated geopolitical and trade tensions, and ongoing questions about the independence of the U.S. Federal Reserve, also could weigh on the demand for dollars.

Smaller non-U.S. companies offer both attractive valuations and an outlook that appears to be strengthening on many fronts. As a result, the T. Rowe Price Asset Allocation Committee recently initiated a significant overweight position in international small-cap stocks.