The case for a small-cap rebound

For the past year and a half we have watched as megacap tech led an initially quite narrow rally in stocks. More recently, the gains have broadened to include a wider range of firms and not just the Magnificent Seven, but the rewards have remained uneven. Small caps have seen some gains, with the Russell 2000 rising 26% since October of 2022, but those results pale when compared with the S&P 500, up 46% over the same period and large cap growth as measured by the Russell 1000 Growth up 62%. Small caps are trading at a wide discount to large caps, with small cap tech stocks underperforming large cap tech by 40% since early 2021.  

Given their historical volatility and their role as a cycle multiplier, one would expect to see small caps outperform if the bull market has legs. I think we will see that happen, but interest rates are still holding them back.

The rates signal that small caps need

Small caps are typically more sensitive to interest rates as they use external financing for growth. The Federal Reserve’s policy rates thus have a disproportionate impact on small- versus large-cap companies. It’s likely that small caps need more clarity that the much-postponed Fed cuts are truly here before the rally begins in earnest.

What about inflation, though? Will it really come down? Inflation might be stickier than expected, but don’t panic; it is not reaccelerating, and further Fed hikes don’t look to be in the cards. I don’t think small caps need big cuts to benefit; they may need rates to start heading lower and for that we need inflation to decline further. With the headline Consumer Price Index (CPI) down from a high of 9.1% in June 2022 to a current rate of 3.3%, much of the inflation battle has been won. This week’s CPI reading was encouraging, with prices unchanged on the month for the first time since 2022. Now the economy needs a bit more time to digest the rate hikes that have already occurred.

Global central banks are tilting towards a dovish stance as most rate-hiking schemes are complete and beginning to reverse. Unusually, the U.S. may not lead the rate cuts this cycle, but we do believe cuts will come here, too. The Europeans have already begun to cut because their fragile economies are more in need of immediate help from lower rates.

Small-cap themes

Within the small-cap universe, two themes call for particular mention: 

• Biotech: Particularly sensitive to rates are small-cap biotech stocks, which are still down 50% from the highs of 2021.
• M&A: Small caps are particularly helped by mergers & acquisitions, which are picking up since large-cap companies are sitting on record cash, growth is slowing and large companies’ need to create growth is greater than ever. The AI buildout will not happen by large companies alone, and many small AI companies are likely to be purchased by big firms.