A US small-cap awakening: Positive momentum for 2025

A small-cap awakening could be underway. Investor sentiment has improved for this segment of the market, driven by a shift in performance leadership and positive fundamental factors. Since July 10, the S&P SmallCap 600^® Index has approximately doubled the return of the S&P 500^® Index, marking a significant turning point for the asset class (Figure 1).

The recent rally in small-cap stocks followed a softer Consumer Price Index (CPI) report in early July. This allowed the Federal Reserve (Fed) to implement a 50 basis-point interest-rate cut, a move that has historically favored small-cap stocks. The momentum continued after the U.S. election, driven by optimism around the new administration’s anticipated pro-growth economic policies, which could also have positive ramifications for small caps.

We believe several factors position small caps for continued momentum in 2025, including favorable macroeconomic conditions, domestic policy tailwinds, and appealing relative valuations.

Favorable macro conditions

The current environment – characterized by broadening economic growth, moderate inflation, and easing monetary policy – has supported small cap outperformance in the past.

Small caps have historically outperformed in the year following Fed rate cuts, a pattern we are witnessing again. While inflation remains above the Fed’s 2% target, further rate cuts are expected, though at a more measured pace.

Lower interest rates reduce companies’ funding costs and make long-term earnings trajectories more attractive. This is particularly significant for smaller companies, which tend to have a higher proportion of floating rate debt compared to larger firms. Additionally, lower inflation could disproportionally benefit small-cap earnings expansion due to their typically lower pricing power and higher labor intensity.

Domestic policy tailwinds

U.S. small-cap stocks stand to benefit from the ongoing deglobalization of supply chains, often called reshoring or onshoring. An increasing tariff regime creates opportunities for companies with greater exposure to the U.S. economy. Since small caps generate less revenue from outside the U.S. than their large cap peers, potential trade barriers could further enhance their attractiveness.

The incoming administration is likely to prioritize domestic growth through policies including tax cuts, targeted fiscal stimulus, and deregulation. These approaches could provide support for small-cap stocks, which are more economically sensitive than their larger counterparts. We expect small-cap earnings growth could exceed that of large-cap stocks in 2025, aided by easier earnings comparisons.

Attractive relative valuations

Currently, small caps are trading at a discount to large-cap stocks, offering an attractive entry point. The relative valuation on a forward price-to-earnings basis sits at a historically appealing level (Figure 2). This valuation gap, combined with potential higher earnings growth rates, makes the asset class a compelling investment opportunity.

Notably, it is important to recognize that the small- versus large-cap performance cycle operates in long cyclical patterns, with outperformance periods typically lasting between six and 14 years. We are currently in the 13^th year of a large-cap outperformance cycle and potentially at the early stages of an extended small-cap outperformance cycle.

Risk considerations

While our outlook is positive overall, two underappreciated risks warrant careful consideration. First, aggressive tariff policies could create significant inflationary impacts and potentially restrain consumer spending, which drives about 70% of U.S. economic growth. While the market currently prioritizes growth potential over the risk of an inflation resurgence, the initial policy enthusiasm may moderate.

Second, potential changes from government efficiency initiatives could create headwinds for sectors previously viewed as benefiting from the status quo, such as healthcare and defense.

Navigating market complexities

We believe the current environment offers ample opportunities for active stock selection. Wide dispersion exists in valuations, quality, and growth prospects within the small-cap universe. Notably, 36% of Russell 2000 constituents remain unprofitable. By focusing on high-quality companies with strong fundamentals and growth potential, we believe investors can better capitalize on opportunities presented by this asset class.

As investors increasingly recognize the potential of this asset class, we believe small caps are well positioned to maintain positive momentum. Furthermore, the current economic and fundamental drivers combined with attractive valuations make small caps a compelling investment consideration for the year ahead.

Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.