Good morning. US stock markets were about as ugly as one might have expected yesterday, given that Monday was a holiday and the president spent the weekend talking about seizing territory from a Nato ally. Declines were very broad. Only 100 S&P 500 constituents rose, and the only sector that gained was consumer staples. Tech was down 3 per cent, led by the Formerly Magnificent Seven. Treasury yields edged up all along the yield curve. Donald Trump was not the only culprit: Japanese long bonds fell hard ahead of the snap election there. We will write more about Trump and Japan in days to come. Send us your thoughts: [email protected]
Tariffs and the court
The Supreme Court may rule as soon as this week on the legality of Trump’s “emergency” tariffs — those levied under the International Emergency Economic Powers Act. These include both the “liberation day” measures and the fentanyl levies on Canada, Mexico and China, together accounting for about half of the tariff increases under Trump. But the decision is likely less important than how the Trump administration responds to it.
Prediction markets are only pricing in a 30 per cent chance of the court ruling in favour of the administration. This seems about right. Using IEEPA as Trump has is unprecedented, and the justifications are flimsy: Treasury secretary Scott Bessent has said that “the national emergency is avoiding a national emergency.” A rejection will not deter the White House, however. Trump has made it clear that tariffs will continue to be his weapon of choice. More product-specific tariffs and quotas, as well as temporary duties under Section 122 of the Trade Act of 1974, are likely.
The new tariffs may take time, and the prospect of a brief window of lower tariffs might prompt businesses to frontload imports again as they did in 2025, creating similar distortions in measurements of GDP. From a markets perspective, the decision will probably result in just a short-term reaction. According to Ed Mills of Raymond James:
Given that most tariffs are likely to remain in place, the market should have a relatively muted reaction. We did see, during oral arguments, a reaction in retail stocks. But we would caution folks not to . . . overinterpret immediate market reactions to the Supreme Court decision . . . The administration that has been aggressive in their use of their authorities and creative in their interpretations of those authorities. That’s not going to go away.
Eswar Prasad of Cornell University, on the ground from Davos, agrees that
the discussions I’ve had around the halls here are basically that the countries are all waiting for [Trump’s] speech with bated breath, but nobody’s waiting for the Supreme Court decision with bated breath, because there is a strong sense that the administration has enough tools to put things back on
The ruling won’t affect the tariffs implemented under Section 232 (regarding imports threatening national security, eg the steel and aluminium tariffs) and 301 (targeting unfair foreign trade behaviour, such as China duties) or trade deals signed post- “liberation day”. So the tariff burden relief for households would be “meaningful, but not nearly as large as eye-popping import tax rates . . . might suggest”, according to a note from the Urban-Brookings Tax Policy Center.
A bigger tail risk would be the court ordering the Treasury to refund the duties collected. This is not seen as a likely scenario. But Paul Ashworth of Capital Economics estimates the bill for IEEPA-related duties comes to about $110bn, or a meaningful 0.4 per cent of GDP.
Trump could replace some of the lost revenues from IEEPA tariffs by the other more product-specific measures. But these, as do the other replacement measures, carry their own economic risks, most importantly even more business uncertainty. Mills again:
When I’ve talked to investors over the past month, the consensus that I had gotten was that because the president is focused on affordability, tariffs are biased to be going down. But part of the market reaction we’ve seen due to the ultimatums related to Greenland is a debate on whether or not that consensus was wrong, and that we are not past peak tariff volatility, and we might not be past peak tariff rates.
(Kim)
Small caps
Yesterday we made the case for mid-cap US stocks: cheap, diverse and suddenly moving in the right direction (up). Today we turn to small caps, which offer a somewhat different proposition.
With small caps, it really matters which index you use. The most popular benchmark is the Russell 2000, but I think for most investors the S&P SmallCap 600 is much better. The main difference is that the S&P 600 only includes companies that have “a track record of positive earnings”, whereas the Russell is perhaps 40 per cent unprofitable companies. I think investing in unprofitable companies is a very different game than investing in profitable ones, and I don’t know why you would mix the two in one index. And I suspect this odd mixture helps to explain the Russell’s consistent and significant underperformance versus the S&P 600 (and I am willing to guess the poor performance of the Russell is why small-cap fund managers prefer to use it as a benchmark).
Another procedural point: when setting long-term return expectations for small caps, the time period really matters. Here is the past 15 years:
Big caps look dominant, and the S&P mid- and small-cap indices look interchangeable. Now look at 30 years:
Mid caps outperform small caps, and both of them outperform big caps — as theory says they should, to compensate for their higher volatility. Of course, this is part of the appeal of moving down the capitalisation spectrum now: that this historically normal and theoretically explicable outperformance will reassert itself. This hopeful view is the flipside of the notion that megacap tech, with its increasing returns to scale, has rewritten the rules of finance in the past 20 years. You can tell almost everything you need to know about an investor by asking which side of that coin they prefer.
Like the mid caps, the small caps’ long stretch of underperformance versus the S&P 500 reversed back in November:
The small caps discount to the S&P 500 is even bigger than the mid caps:
On sector exposure, the mids and smalls are broadly similar, though the S&P 600 is lighter on industrials and heavier on healthcare and financials. But there is a crucial difference: small caps are even more volatile and economically sensitive than mid caps. And right now, that momentum is on the upturn:
Bank of America’s Jill Carey Hall describes the upside potential:
[Small caps’] long-awaited profits rebound is here (with support from positive guidance): consensus expects +18 per cent EPS growth for small caps vs 16 per cent for mid and 13 per cent for large in ‘26, where history suggests small caps typically lead in backdrops of accelerating and better-than-large-cap profits growth. [Earnings estimate] revisions have also shifted more favourably for small vs mid.
If you, like Unhedged, endorse the consensus view that broad economic momentum will accelerate in 2026, small caps will benefit the most. But that cuts both ways: if the consensus view is wrong, it will be wronger about small caps. Dec Mullarkey of SLC Management sums up:
Mid-cap companies tend to have more pricing power and fixed-rate debt [than small caps], providing more predictability on margins and opportunities for scale . . . If the economy is booming, small-cap companies tend to flourish as profits ramp up. And some become acquisition targets . . . [but] in a low to moderate growth environment, mid-cap earnings tend to be more stable
Unhedged is conservative and likes mid caps better.
(Armstrong)
One good read
The global state of play.
Read the full article here