Key Takeaways
- Small-cap stocks continued to climb on Wednesday, extending the previous session’s gains following a better-than-feared consumer price index report.
- Tuesday’s inflation data raised Wall Street’s expectations that the Federal Reserve will cut interest rates at its next policy meeting in September, which would be a boon for rate-sensitive small caps.
- Bank of America analysts expect small caps to benefit long term from modest valuations relative to large caps, light investor positioning, and President Trump’s reshoring agenda.
Small-cap stocks continued their march higher as investors doubled down on bets that interest rate cuts are imminent.
The Russell 2000 (RUT)—the benchmark small-cap equity index—rose 2% on Wednesday, hitting its highest level since December. Small caps built on yesterday’s 3% gain, which was fueled by a better-than-feared report on consumer prices. The data showed that Inflation held steady at 2.7% in July, surprising Wall Street, which was braced for tariffs to cause prices to rise faster.
Morgan Stanley analysts on Monday predicted that the odds of a rate cut in September—around 90% at the time—would rise if yesterday’s report showed few signs that tariffs were materially affecting consumer prices. “This has the potential to catalyze a more durable rotation to small caps and lower quality stocks,” the firm said.
Tuesday’s data appears to have convinced investors that the Federal Reserve will look through tariff-driven inflation at its policy meeting next month. As of late Wednesday, traders saw a 96% chance of a quarter percentage point cut in the benchmark interest rate, according to CME Group’s FedWatch Tool.
“The prospect of rate cuts bodes well for many of the traditional value sectors and small cap stocks that we have recommended clients should overweight,” said Eric Teal, Chief Investment Officer at Comerica Wealth Management, on Wednesday. “These areas have lagged the technology and growth sectors and are primed to lead the market higher as breadth expands.”
Rate Cuts Could Give Small Caps a Big Boost
Small-cap stocks benefit disproportionately from lower interest rates because they are more likely than large companies to rely on credit to fund growth, and are more likely to have floating-rate loans. They also tend to operate more domestic businesses, and thus benefit more than multinationals from the stimulative effects—boosted consumer and business spending—of lower rates.
A rate cut next month would come at an opportune time for small-cap investors. Small caps grew earnings for the first time in more than a year last quarter, and are expected to outpace mid and large caps throughout the second half, according to Bank of America.
Granted, relative to large caps, small caps underperformed last quarter in sales growth, and executives were notably more downbeat on earnings calls, says BofA. And microcaps—the smallest quintile of small caps—are trading at historically rich valuations after rebounding from early April’s “Liberation Day” rout.
But analysts see plenty of reason to be bullish on small caps in the long term, including “extreme relative cheapness,” light investor positioning, and domestic reshoring efforts.