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Small cap equities: What could fuel a sustainable rally?

August 20, 2025 | 5 min read
Magdalena Ocampo
Market Strategist
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Leading up to August, this year’s equity rally favored large caps, which significantly outpaced the less-tech heavy small caps. In recent weeks, however, small caps have gained traction, with the Russell 2000 outpacing the S&P 500 by 2% as of August 18. While the rising probability of a September rate cut, and support from attractive valuations, have been the catalysts for a small cap rally, whether this will be a short-lived bounce or a sustained recovery likely hinges on a growing economy, a meaningful decline in interest costs, and supportive fiscal, regulatory, and trade policies.

Small cap rally in August: noise or beginning of a trend?

Despite this year’s challenging policy backdrop, the S&P 500 has demonstrated resilience, delivering close to a 10% gain since the start of the year. Since the April market trough, robust macro fundamentals have prompted a revival in risk appetite, but with investors largely favoring large cap U.S. equities over small caps.

For most of this cycle, the less tech-heavy Russell 2000 has been left on the sidelines of the AI productivity growth story, with earnings unable to match the S&P 500’s pace. Notably, continuing large cap outperformance in recent months has stretched the valuation gap between large caps and small caps to its widest levels in over a decade.

That valuation gap is drawing investor attention as the macro backdrop begins to shift. Recent economic indicators, such as July’s weaker payrolls data and cooler inflation, suggest a more favorable environment for small caps. Yet valuations alone won’t drive a recovery—sustained performance will depend on both improved fundamentals and a more supportive economic setting.

While a September rate cut could spark near-term momentum, a lasting revival in small cap performance will likely require more than one policy move. Earlier this year, small caps faced multiple headwinds—slowing economic activity, elevated rates, tariff uncertainty, and policy disappointment on taxes and deregulation. For small caps to sustain outperformance, some of these macro pressures will need to ease, creating a more supportive backdrop for earnings growth.

A healthy and growing economy is the backbone of riskier small caps

Across history, periods of strong small cap performance are generally supported by an economy that’s firing on all cylinders. When economic activity is strong and earnings can deliver, the relatively lower valuations of small caps can attract investors seeking upside potential. However, during slower growth periods, thinner margins, higher insolvency rates, and volatile revenues often make small caps less compelling.

Even though the economy has avoided a hard landing this cycle, the lack of momentum in economic indicators has not been conducive for small cap stocks. Therefore, a convincing rebound in leading indicators—like manufacturing surveys, housing activity, consumer and business sentiment, and employment statistics—may be required to support small cap earnings and a longer-term rally.

Preemptive rate cuts aimed at stimulating growth would be a tailwind

The interest rate environment has been a persistent headwind to small cap margins this cycle. Smaller companies generally have more leveraged business models and typically rely on banks to borrow. Their debt is largely issued as floating rate, making it subject to frequent interest rate adjustments. As such, small cap borrowing costs rose alongside the fed funds rate since the spring of 2022 and negatively impacted earnings.

Larger companies, on the other hand, often have an upper hand with access to capital, offering longer-term and fixed-rate debt advantages that keep borrowing costs more contained. The inversion of the yield curve this cycle specifically favored large companies, as smaller firms pay higher interest costs for borrowing at the shorter end of the curve.

Small caps have welcomed the growing likelihood of Fed easing in September. And yet, history shows that the factors behind the rate cuts are critical for the asset class: cuts made in the depths of recession have hurt small cap performance, while preemptive cuts in stable conditions have fueled strong gains. Today’s backdrop—subdued growth, contained inflation, and limited recession risk—looks more like the latter, setting up a more constructive environment for small cap returns.

Trade policy clarity, tax cuts, and deregulation

Policy headlines were especially disruptive for small companies earlier this year, specifically the “whiplash effect” of abrupt changes in tariff policies as business owners delayed investing and hiring until there was more clarity. Recent positive developments involving deregulation, a tax cut agenda, and a little more clarity on trade policy, however, have improved the backdrop for small businesses.

Deregulation: Easing regulations was a central focus of Trump’s first term, a push that delivered roughly a $1.5 trillion boost to the economy. According to the National Association of Manufacturers, smaller companies are expected to benefit more from deregulation than larger companies, as their annual regulatory costs are roughly 20% higher. Lower regulatory costs could, therefore, strengthen earnings or allow small business owners to shift spending toward expanding operations.

Tax cuts: Unlike C-corporations that benefit from a permanently lowered corporate income tax of 21% (from 35% before the 2017 TCJA was passed), the 20% qualified business income deduction for pass-through entities that allowed small business owners to save on taxes was set to expire at the end of this year. The One Big Beautiful Bill Act (OBBBA) provided a huge relief for small businesses worried about the automatic tax hike that could have gone into effect next year. Without action, pass-through entities would have likely faced a disadvantage to C-corporations.

The OBBBA didn’t just provide a postponement of a substantial tax increase—it delivers a permanent extension and enhancement by expanding eligibility and a minimum deduction, designed to support small businesses. Indeed, companies that cited tax cut benefits during Q2 earnings calls noted that softer consumer spending could be cushioned by OBBBA’s tax provisions, keeping free cash flow steady courtesy of lower tax payments.

Tariffs: Even though small companies have a more domestic-focused customer base, their supply chains are not necessarily all in the U.S. For instance, according to U.S. Census data, companies that employ less than 50 workers rely on China for around 20% of their import value. Unlike larger companies, small companies operate on thinner margins and therefore have less flexibility to order in bulk or the agility to switch suppliers to adapt to rapidly changing policies.

While some trade agreements have been reached, and the harsher tariffs on China have been delayed further, trade policy is likely to remain fluid in the months ahead. Nevertheless, in Q2 earnings calls, small companies highlighted that the cost of tariffs has not been as harsh as initially perceived. To counter the adverse effects of tariffs, small companies have increased prices, reduced costs, or pressured suppliers, highlighting that the net impact of tariffs has been quite manageable.

Overall, tax provisions and deregulation efforts support small business and while there is still concern about trade policy, tariffs are not yet significantly pressuring balance sheets.

Investment implications for investors

Even though investors still need to confront lingering risks, tax policy and deregulation will likely strongly support small caps, further amplified by preemptive Fed easing. Combined with attractive valuations, this sets the stage for the potential of a durable upswing in small caps—provided the broader economy remains resilient.

For investors still wary of the small cap space given the macro headwinds, an active management strategy could mitigate some of the idiosyncratic risk specific to some industries.

  1. Economic activity uncertainty: Emphasizing profitable industries whose bottom line would benefit from supportive regulatory and fiscal policies
  2. Interest rate uncertainty: Avoiding unprofitable industries with inherently leveraged business models and significant floating-rate debt
  3. Tariff policy uncertainty: Emphasizing profitable industries with either high pricing power or a domestically-focused supply chain
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