Insights
InsightsUS small caps: From slight to significant
With the Fed's decisive pivot toward easing, small cap investors are facing one of the most compelling entry points in years. Time to reassess your exposure?
Authors
Christopher Colarik
Head of US Smaller Companies
Tom Harvey
Senior Equity Specialist
Contributors
Joe Rava
Duration: 5 Mins
Date: Sep 30, 2025
Could the Federal Reserve’s (Fed) policy shifts mean a potential break out to come for US small caps?
We believe the Fed’s recent 25 basis point rate cut – the first since December 2024 – has turned what was a “slight” opportunity into a “significant” one. With monetary policy shifting from restraint to support, the asset class is poised to emerge from the shadows of its large cap counterparts.
Lower borrowing costs, improving fundamentals, and discounted valuations are converging to create a rare moment of potential leadership. For investors seeking growth in a changing macro landscape, small caps may no longer be the underdog, but the pup that may just be ready to lead the pack.
Why monetary policy matters more for small cap investors
Small cap companies are uniquely sensitive to changes in interest rates. Historical data – since the 1950s – shows that smaller companies have outperformed larger peers following the first rate cut, and the current economic environment may support this trend (Chart 1).
Chart 1. Small cap vs. Mid and large cap after first rate cuts
Unlike their large cap counterparts, which often have diversified global revenue streams and stronger balance sheets, small caps tend to:
- Carry more floating-rate debt, making them more vulnerable to rising interest costs – and larger beneficiaries of rate cuts.
- Rely more heavily on domestic demand, which is directly influenced by consumer spending, business investment, and credit conditions.
- Operate with tighter margins, meaning any reduction in borrowing costs can have a disproportionately positive impact on profitability.
The Fed’s September rate cut, combined with its forward guidance suggesting further easing if inflation remains contained, has already begun to shift investor expectations. Lower rates reduce the discount rate applied to future earnings, which is particularly beneficial for small caps with longer growth runways.
A catalyst for repricing
Amid signs of cooling inflation and slowing job growth, the reduction gives the Fed room to support the economy without reigniting price pressures. For small caps, we believe this move was a game-changer. It not only lowered financing costs but also boosted investor appetite for risk, leading to a sharp rotation into more volatile, higher-beta names.
This environment has favored the kind of speculative rally typically seen in early-stage recoveries. Since the reciprocal pause in tariffs, the Russell 2000 has outperformed the S&P 500, 35.1% vs. 30.8%, respectively – a rally that has been led by unprofitable, low-priced, and heavily shorted stocks (Chart 2).1,2
Chart 2. Gross performance pre- and post-tariff pause
Macro tailwinds
The Fed’s dovish pivot is not occurring in isolation. Several macro factors are converging to support small caps.
Combating mega-cap concentration with small cap diversification
After years of dominance by the Magnificent Seven, investors are increasingly looking to diversify away from concentrated large cap exposures. Small caps offer broader sector representation and more domestic focus.
Improving earnings growth
Lackluster earnings growth is partially responsible for small cap underperformance in recent years. However, as borrowing costs decline and operating conditions improve, we believe small cap earnings are poised to outpace those of larger peers over the next 1–2 years.
We believe that the current shift is influenced by declining interest rates, which reduce financing pressures for smaller companies, along with a favorable domestic policy environment. As valuations remain at a discount and fundamentals show improvement, small cap stocks may be entering a new phase of leadership.
Acting on attractive valuations
Small caps continue to trade at a significant discount to large caps, with relative price-to-earning ratios well below historical averages. Coupled with stronger earnings growth, this valuation gap positions the asset class as particularly compelling in a lower interest rate environment (Chart 3).
Chart 3. Small cap relative to large cap forward price/earnings (PE) ratio
The Fed’s September rate cut, combined with its forward guidance suggesting further easing if inflation remains contained, has already begun to shift investor expectations. Lower rates reduce the discount rate applied to future earnings, which is particularly beneficial for small caps with longer growth runways.
A new cycle of small cap leadership?
Historically, small cap leadership cycles last between 6–14 years. With large caps having led for the past 13 years, and the Fed now actively supporting growth, the conditions are ripe for a regime change (Chart 4).
Chart 4. Cyclical trends for the small cap asset class are favorable (1931–2024)
We believe it’s possible that this marks the beginning of a more sustained period of small cap outperformance over large, but that will depend on continued follow through in small cap fundamentals to maintain momentum.
The September rate cut may be remembered not just as a tactical move, but as the beginning of a structural shift in market leadership.
This disparity presents a unique opportunity for investors to buy into small caps at attractive valuations. For investors, this is a moment to reassess allocations. The combination of monetary easing, attractive valuations, and improving fundamentals positions small caps as a compelling opportunity – not just for short-term gains, but for long-term portfolio growth.
Final thoughts
The Fed’s pivot toward easing has fundamentally altered the investment landscape. For small caps, the September rate cut is more than a relief, it’s a catalyst. As borrowing costs fall and investor appetite for risk returns, small caps stand to benefit disproportionately. While the initial rally has favored speculative names, history suggests that quality will eventually lead. For investors willing to look beyond the noise, we believe the Fed’s dovish turn offers a rare window to enter – or re-enter – the small cap space at a moment of profound opportunity.
Endnotes
1 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.
2 The S&P 500® Index is an unmanaged index considered representative of the US stock market.
3 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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