Nominal growth, not yield levels, is the metric for small caps: Goldman Sachs

A framework contained in the note makes a case for holding small caps even with elevated Treasury yields, potentially supporting rotation into the segment if growth data remains firm. The trade-off is that this thesis relies directly on nominal growth, making small caps potentially more reactive to economic data surprises rather than yield movements; a weaker PMI or GDP figure could pose a greater risk than a rate increase. Goldman Sachs’ perspective that inflation is heavily energy-focused ties the outlook to oil prices—a new surge in crude would challenge the idea that broader inflation is easing. The focus on dispersion implies that broad exposure to small caps through an index may underperform a more targeted stock-picking approach.

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Previously:

• Netflix tops Q3 profit forecast but trims two full-year targets as Q4 guide disappoints
• SpaceX beats Q3 forecasts across all three segments as AI revenue tops $7.5 billion

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Small-cap investors are tracking the wrong figure, according to Goldman Sachs; the growth environment, rather than the 10-year Treasury yield, dictates the viability of the asset class.

Highlights:

• The essential question for small caps, Goldman Sachs states, is sustained healthy nominal growth, not simply the 10-year yield being below 5%.
• Small-cap performance has historically been strongest when nominal GDP is above 5% and gathering pace; the current level is close to 6%, with real GDP at about 2.3%.
• Goldman Sachs observes that small caps have typically produced positive returns in times of rapidly climbing interest rates.
• It projects U.S. growth of about 2.3%, unemployment around 4%, and limited recession risk, with PMIs at their highest levels in more than five years.
• Inflation is less broad than top-line data suggests, according to the bank, with much of the pressure traced to energy.
• Valuations are appealing compared with large caps and past trends, and a rising cost of capital should encourage active stock picking.

In a recent note, Goldman Sachs advises investors evaluating small-cap stocks to look past interest rate levels and concentrate on nominal economic growth, arguing that the current growth landscape is supportive for the segment.

The real test for small caps, the bank argues, is whether nominal growth stays healthy, not if the 10-year Treasury yield is above 5%. Goldman Sachs points out that small caps have historically done best when nominal GDP—the sum of real growth and inflation—is above 5% and accelerating. Presently, nominal GDP is around 6% year-on-year, with real GDP at approximately 2.3%.

Higher rates by themselves have not historically been a deterrent for small caps, according to Goldman Sachs, which observes that the group has mostly recorded positive returns in periods of brisk rate hikes.

The bank's wider economic outlook backs this position. It sees U.S. growth of around 2.3%, unemployment close to 4%, and a fairly contained recession risk, while PMIs have hit their highest readings in more than five years. Goldman Sachs adds that inflation appears less pronounced than top-line data implies, as much of the pressure originates from the energy sector and broader indicators keep easing.

On company fundamentals, Goldman Sachs reported that earnings strength among smaller firms seems to be expanding across a wider group rather than clustering in a few names. It characterized valuations as appealing compared to both large companies and historic norms, providing a strong entry point on top of improving basics.

A rising cost of capital lifts the bar for companies, rewarding profitability, sustainable earnings, and solid capital returns while penalizing weaker entities, Goldman Sachs stated. This growing divergence between strong and weak performers, the bank suggested, could create a more supportive setting for stock selection and active portfolio management.

The entire thesis depends on growth remaining steady. If nominal GDP decelerates significantly, or if energy-led inflation spurs broader price increases that push interest rates higher, the supportive environment for small caps that Goldman Sachs identifies would erode. For the moment, the bank views the growth landscape as the dominant factor, playing a larger role than the yield discussion implies.