Why we’re sticking with small-caps amid the great reshuffle

“All the signs of a market regime change are there.”

“We’re going through the greatest technology transition ever. Think about it: we’re harnessing intelligence. This is profound. Security analysis frameworks that took me 20 years to build, I can now do in five minutes. And the pace at which the tools are improving is stunning.”

Those comments from committee members highlight the tenor of our February Asset Allocation Committee meeting. The consequence of continued gains in artificial intelligence (AI) could be something we haven’t witnessed in more than 20 years: a durable, productivity-driven acceleration in economic growth.

Valuation levels in both equities and credit suggest the market is pricing in such a scenario. At the same time, investors are grappling with how value will be distributed across sectors and business models. Last week, a Wall Street strategist described the AI trade’s impact on software, wealth management, trucking, logistics, and other disruption-prone industries as a “heat-seeking missile.”

How will the “great reshuffle” unfold? Where will value accrue—to consumers, hardware producers, real asset owners, or asset-light platforms?

These are hard questions, and the answers may change over time. For now, however, we continue to overweight small-cap stocks among other tactical positions. If productivity gains lift economic activity beyond a narrow group of dominant platforms, equity market leadership should continue to widen.

Why small-caps?

Small-caps, in particular, offer what one member described as “triple merits”:

1. Policy. U.S. policy is tilted toward domestic growth. Beyond trade dynamics that favor U.S.-oriented businesses, enhanced depreciation and expensing allowances and lower effective tax rates under the One Big Beautiful Bill Act disproportionately benefit smaller companies. The impulse is domestic and pro-growth.
2. Valuation. Relative valuations can provide a meaningful buffer. Small-caps trade at a discount to large-caps on most metrics, reflecting years of underperformance.
3. Interest rates. Lower rates ease financing conditions and reduce interest expense, particularly for smaller firms, which tend to be more sensitive to short-term borrowing costs. A policy bias toward accommodation improves the earnings outlook for small-caps and supports balance-sheet repair.

Wrecking ball

“AI can support margins—or become a corporate value wrecking ball,” a committee member emphasized. It’s a different metaphor than the heat-seeking missile, but the impact is the same: we believe dispersion will be wide across industries, with significant implications for the broader economy and society.

What we know is the starting point. Market concentration is historically elevated. If this is a genuine transition in the market regime—particularly one rooted in productivity—the beneficiaries may extend beyond large technology platforms.

Where could we be wrong? We are mindful of tactical risks. “Small-caps have enjoyed outperformance over the past month and a half,” one member noted. Positioning has shifted quickly.

Still, tactically, “Small-caps can be attractive on the downside given the valuation buffer,” a committee member said. “And if the economy improves, they should do well.” We like this asymmetry.

Bearish on the dollar

The fiscal backdrop remains central. Deficit concerns are expressing themselves less through U.S. Treasury selling and more through real asset demand. “Those worried about deficits seem to prefer buying gold rather than selling Treasuries,” one member observed.

Another put it bluntly: “Short USD, long gold is the new short duration. Yield management makes the dollar vulnerable.”

What we once viewed as a tail risk—coordination between the U.S. Federal Reserve, U.S. Treasury, and the White House to keep rates contained—now looks closer to the base case. This reinforces our bearish view on the U.S. dollar and our constructive outlook on real asset equities.

Stocks vs. bonds

Some members expressed discomfort that, by certain measures, equity valuations exceed levels seen at the peak of the dot-com era.

For now, we remain neutral between stocks and bonds. The macro backdrop is supportive: fiscal and monetary impulses remain constructive, and AI capex is running hot. Fundamentals are solid, too. Earnings growth is healthy, and operating margins remain near historic highs.

Complacency is among the risks. “It’s consensus that the first half is going to be risk-on,” a committee member noted. “That’s worrisome.”

Takeaways

We are positioned for broadening while remaining disciplined on valuation and mindful of crowding risks.

Our base case is an early-stage transition characterized by productivity acceleration, broader equity leadership, and policy that leans toward easier financial conditions, particularly into the midterm election cycle.

Market regime shifts unfold unevenly. The pace of technological improvement is rapid, but whether those gains translate into sustained productivity—and how they are distributed—remains highly uncertain.