History has shown that betting on US small caps after a presidential election generally pays off, especially if the backdrop boasts: a growing economy (check), interest rate cuts (check), and favorable policies (check).

And yes, this time could be different, especially if new inflation pressures force the Federal Reserve (Fed) to hold off on cutting interest rates. But, with a raft of new proposals and a shift in market dynamics since the last election, it’s worth considering the prospects for small caps in the year ahead. Here are a few things that stand out.

First, a look at the initial market reaction.

The new White House is expected to drive significant gains in small-cap stocks. And, in fact, the Russell 2000 Index – which tracks US small-cap firms – has already seen substantial gains. And that likely reflects investor optimism.

Now, small-cap stocks are traditionally more focused on the domestic market, with far less exposure to international trade and currency fluctuations, compared to their big-cap cousins. And that could prove particularly advantageous in the next few years, with the new administration's America-first policies and potential trade restrictions potentially creating obstacles for US companies that do have significant international exposure.

Here are some of the potential advantages that could be just around the corner for America’s smaller-sized companies:

Possible tax changes.

The prospect of corporate tax cuts as the former president returns to the White House could disproportionately benefit small-cap firms. Unlike big multinationals that often have complex international tax structures, small caps typically pay closer to the full US corporate tax rate. So any reduction in corporate tax rates would have a more direct and significant impact on their bottom lines.

Looser regulations.

The next administration is expected to ease all sorts of regulatory requirements, which could be a boon for more modest-sized companies – which often face disproportionately high compliance costs, relative to their smaller stature.

Firstly, fewer rules would mean fewer costs to meet them. And that’s good for smaller firms, which typically can’t allocate as many resources to rules oversight. Lessening this burden would free up capital that could be reinvested into growth efforts – like research and development or expansion.

Secondly, faster product approval processes would give smaller firms a boost. Lengthy, complex approval procedures extend the time it takes to bring new products to market. Streamlining all of that would enable companies to launch goods more quickly, giving them a competitive edge and speeding them toward the revenue generation part of things.

Thirdly, easier access to capital markets could be a crucial advantage. Regulatory requirements can create barriers for small-cap companies that want to raise funds through public offerings or other means. With lower hurdles, small caps could find it easier to get the capital they need to grow and scale their businesses.

Finally, a more flexible operating environment would allow small-cap firms to adapt more readily to market changes and opportunities. Reduced regulatory constraints could allow them to innovate and respond to customer needs more nimbly, enhancing their overall competitiveness.

Lower interest rates.

The Fed’s anticipated rate cuts are another factor that could boost small-cap stocks. After all, lower borrowing costs are particularly beneficial for smaller companies – which tend to have heavier debt burdens. Plus, those lower lending rates tend to give a boost to consumer spending and economic output overall.

Because of the limited size of these small-cap companies, they often have more room to grow. They can be more flexible than big caps, adapting to changing market conditions. Less analyst coverage in this space allows for a better chance for active managers to find undervalued, hidden gems.

Overall investor sentiment.

The mood of the market has been a little lighter since the election, with so much political uncertainty erased from the picture.

The S&P 500 and other major indexes have also rallied, reflecting optimism about the new administration’s policies. And, though there are still risks and unknowns, that appears to be setting the stage for good times for small-cap stocks.

–Christopher Colarik is a small-cap portfolio manager at abrdn. Tom Harvey is a senior equity specialist at abrdn.