US small caps: A tale of two halves

The year has unfolded in two distinct chapters: the tense months before Liberation Day and the more hopeful period that followed. Early uncertainty cast a shadow over markets resulting in a risk-off environment. But after April 8, the pause in tariffs allowed a new narrative to emerge, one of renewed optimism as the Russell 2000 began to outperform the S&P 500 (Chart 1).

Like Dickens’ classic, the story of US small caps is one of contrasts: defined by the delicate balance between risk and opportunity, investor skepticism and resolve. As we look ahead to 2026, investors must decide which chapter will define the future and whether this tale of two halves will ultimately become one of transformation. Fortunately, we believe there are reasons to be optimistic.

A strong earnings trajectory

One of the most persuasive arguments for small cap optimism in 2026 lies in the projected earnings growth. Companies within the Russell 2000 index are expected to deliver 19% year-over-year earnings growth, meaningfully outpacing the S&P 500’s forecasted 13% growth.¹

We believe several fundamental forces support this anticipated surge in small cap earnings: fiscal and monetary policy tailwinds, reduced trade-related uncertainty, easing cost pressures, early signs of improving demand across various industrial and consumer end markets, and the productivity benefits from continued generative artificial intelligence (AI) adoption. Taken together, this long-awaited acceleration in earnings growth represents a key element for sustained small cap success.

Relief from easing monetary policy

One of the most tangible factors benefiting small cap companies is lower interest rates.

Small cap companies are disproportionately reliant on short-term financing, making them highly sensitive to interest rate movements. The Federal Reserve’s anticipated rate-cut trajectory is expected to significantly reduce borrowing costs for these firms. Lower interest expenses will not only improve profitability but also enhance financial flexibility, enabling companies to reinvest in growth initiatives such as capital expenditures, product development, and market expansion.

This dynamic is particularly important given the challenges small caps faced during the recent tightening cycle. Elevated rates compressed margins and constrained liquidity, forcing many firms to delay strategic investments. The shift toward a more accommodative monetary stance should reverse these headwinds, creating a tailwind that supports both earnings growth and valuation re-rating.

Fiscal policy tailwinds

Fiscal policy is also expected to provide meaningful support through the One Big Beautiful Bill (OBBB), which targets two key drivers of economic activity: consumer spending and capital investment.²

The bill’s provisions for substantial household tax refunds in 2026 should increase disposable income and act as a catalyst for consumption. In addition to boosting consumer demand, OBBB introduces measures to encourage domestic investment by lowering the effective cost of capital, subsidizing strategic industries, and streamlining approval processes for infrastructure and manufacturing projects.

We believe smaller companies, given their domestic revenue orientation and operational agility, are well-positioned to benefit disproportionately from these dynamics, enabling them to capture incremental demand and achieve cost efficiencies ahead of larger peers.

Mind the valuation gap

Valuation is another critical piece of this two-part tale. Small cap stocks are currently trading at a substantial discount – approximately 40% cheaper compared to mid and large cap counterparts (Chart 2). This gap is historically wide and suggests that the market has yet to fully price in the improving fundamentals of these companies. For long-term investors, we believe this presents a compelling entry point.

Historically, periods of pronounced valuation disparity have often preceded strong relative performance for small caps. The discount reflects lingering skepticism after years of volatility and underperformance, but as earnings visibility improves and macro conditions stabilize, this skepticism is likely to fade. When combined with the projected earnings growth, the current valuation levels offer an attractive risk-reward profile for those willing to look beyond short-term noise.

Endnotes

¹ Bloomberg (consensus earnings forecasts), November 2025.
² The One Big Beautiful Bill (OBBB) Act, signed into law on July 4, 2025, introduces significant changes to tax and spending policies in the U.S.

Index glossary

The Russell 2000® Index is an unmanaged index considered representative of small‐cap stocks. The Russell 2000 Index is a trademark/service mark of the Frank Russell Co. Russell® is a trademark of the Frank Russell Co. The S&P 500® Index is an unmanaged index considered representative of the US stock market. The S&P Small Cap 600® Index is a market‐value weighted index considered representative of small‐cap US stocks.

Important information

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

Equity stocks of small and mid-cap companies carry greater risk, and more volatility than equity stocks of larger, more established companies.

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