Small cap stocks emerge as unexpected winners with signs of interest rate cuts on the horizon

Traders are gearing up for what many expect will soon be the first cut to the Federal Reserve’s benchmark interest rate in more than two years, and small-cap stocks are emerging as unexpected winners.

Despite conventional wisdom that would typically assume “risk-on” assets such as high tech stocks and cryptocurrencies to be among the first asset classes to get a bump from the increased liquidity that rate cuts would bring, shares of some smaller companies like Cal-Maine Foods (NASDAQ: CALM) are beating broader market indexes as fresh economic data in the US points toward slowing inflation that would allow the US central bank to begin easing monetary policy.

The logic behind rising small-cap shares is actually quite simple: lower rates should help smaller companies more than they help big ones.

“Higher rates have a greater impact on companies that need to borrow money to finance expansion,” U.S. Bank Wealth Management senior investment strategy director Rob Haworth said, noting that large-cap growth stocks have outpaced gains seen by small-cap stocks over the past year and a half that has been marked by more restrictive monetary policy. “For many smaller companies, the cost of funding at higher interest rates is a bigger concern than it is for larger companies, which have more cash on hand and often issue longer-term debt.”   

Amid rising optimism over the past month that the Fed would soon cut rates, the Russell 2000 Index (NYSE: IWM)—which tracks shares of the smaller companies—has risen 10.3% over the past month compared to declines of 1.3% for the S&P 500 (NYSE: SPY) and 3% for the Nasdaq Composite. Bitcoin, whose traders also closely watch interest rates, rose 4.4% over the same period, while gold (CME: GCQ4) increased 3.3%.

Few expect the Federal Reserve to begin cutting rates at its next meeting this month, but interest rate traders tracked by CME’s FedWatch tool currently place the probability that the central bank will begin easing in September at nearly 92%. Federal Reserve Chair Jerome Powell has signaled he didn’t want to move “too late or too little.” 

Smaller-cap stocks, meanwhile, may also be getting a boost as a hedge for political risk as the US inches closer to a presidential election in November. The Russell 2000 Index remained flat over an extremely volatile week earlier this month that saw Republican presidential nominee Donald Trump literally dodge a bullet and President Joe Biden withdraw from the heated race. The S&P 500 shed 1.5% over the same period, while the Roundhill Magnificent Seven ETF—which tracks Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), Alphabet (NASDAQ: GOOG), Amazon (NASDAQ: AMZN), Meta (NASDAQ: FB), Nvidia (NASDAQ: NVDA) and Tesla (NASDAQ: TSLA)—declined 3.5%.

The outcome of the race is far from certain, but the ongoing campaigning could bring increased volatility to high-profile industries and companies as the candidates comment on issues ranging from geopolitical conflicts to corporate tax rates. The semiconductor industry got an early taste of that when a Trump interview last week sent shares of chipmaker TSMC (NYSE: TSM) plunging.

Smaller-cap companies, which fly under the radar of a more polarized national discourse, may be presenting investors with a strategic haven away from the noisy months ahead. Most market watchers expect rate cuts regardless of whoever wins, and that could let investors buy into the upside without increasing exposure to higher risk stocks more exposed to the political race underway.