Small-cap stocks are grappling with uncertainty around the U.S. economy and Federal Reserve policy, according to analysts.
Despite a significant rally over the past month, where the Russell 2000 Index (RUT) gained 3%, outpacing the S&P 500’s 1.4% rise, concerns linger over the sustainability of these gains. Investors remain cautious as they await clarity on the economic outlook and upcoming Fed decisions regarding interest rates.
Following a sharp 13% jump in July—the Russell 2000’s best month in nearly two years—small caps retraced almost half of those gains in August. Still, market analysts believe the rally may have legs, driven by the potential for interest rate cuts and optimism that the U.S. economy could achieve a “soft landing,” slowing without falling into a recession.
The Importance of Rate Cuts for Small Caps
Smaller companies are more sensitive to changes in borrowing costs than their larger counterparts, making rate cuts particularly beneficial for small caps. As the Federal Reserve is expected to begin lowering rates, many investors see an opportunity for small-cap stocks to continue outperforming.
Valuations also favor small caps, with the S&P SmallCap 600’s forward price-to-earnings ratio at 16.7, compared to 23.4 for the S&P 500. Furthermore, earnings for smaller companies are forecast to grow by 20% by 2025, versus 15% for large caps, per FactSet data. “Rate cuts could reignite interest in small caps,” said Matt Palazzolo, senior investment analyst at Bernstein Private Wealth Management, noting that their cyclical nature and growth potential make them appealing.
What the Size of Rate Cuts Could Mean
While the Fed is widely expected to ease policy, the size of the initial rate cut is still in question. Some traders are betting on a 50-basis-point cut, while others anticipate a smaller 25-basis-point reduction. A larger cut could boost small-cap stocks, though some fear it might signal a sharper economic slowdown, which could harm corporate earnings.
Jordan Irving, portfolio manager at Glenmede Investment Management, noted that small caps need sustained earnings growth for the rally to continue. However, Palazzolo advised not to overemphasize the size of the rate cut, as it is unlikely to impact long-term performance of small caps versus large caps.
‘Value Versus Growth’ Dynamic in Small Caps
Small-cap outperformance is also linked to a broader “value versus growth” dynamic. Sectors like financials and real estate, which are heavily represented in small-cap indices, have performed well in recent months. The S&P SmallCap 600’s financial sector gained 21.6% over the past three months, while the real estate sector rose 18.1%, outperforming their counterparts in the large-cap S&P 500.
This trend aligns with a shift in the market away from megacap tech stocks and toward value-oriented sectors, with small-cap stocks benefiting from this rotation.
