Small-Cap Russell 2000 Shakes Off Four-Year Funk on Rate Cut

Federal Reserve officials lowered the target range for their benchmark interest rate by 25 basis points to a range of 4% to 4.25% — with Chair Jerome Powell flagging weakening jobs data  — and penciled in two more cuts by the end of 2025. Yawn. The only thing less surprising than that yesterday was the calendar showing the day was Wednesday.

But as Powell emphasized the Fed’s jobs, jobs, jobs focus, a winner emerged on the trading floor: the small-cap Russell 2000, a laggard during this year’s market rally that is now on pace to finally break the nearly four-year drought since its last record closing high.

The Little Index That Couldn’t

The S&P 500, naturally, has been on a tear, setting five records this month alone. Some market watchers including Deutsche Bank, factoring in rate cuts as drivers of stock prices, think it can hit 7,000 by the end of the year. The hope for its small-cap cousin, meanwhile, is less ambitious but tells an important story about the broader economy.

The Russell 2000, which tracks the performance of 2,000 smaller companies in the broader Russell 3000 Index, was underwater through the end of June, while the S&P 500 had recovered from the post-Liberation Day tariffs shock by mid-May. But since the end of July, the Russell 2000 has jumped 10%, double the S&P’s rise in the same time. Following the rate cut announcement on Wednesday, the small-cap index rose more than 2% and at one point advanced past its all-time closing high of 2,442.74. It ultimately pared gains and finished up 0.2%, but a new record high, topping the one set in November 2021, seems finally within reach. That’s because of the unique meaning of a rate cut for small-caps:

• Roughly half the companies on the Russell 2000 aren’t profitable, which means they’re often highly leveraged. Lower rates help reduce their interest expenses, since smaller companies rely more on variable financing.
• Bloomberg compiled analysts’ price targets for the index last week and, with the expectation of rate cuts, Wall Street sees the small cap index rising as much as 20% in the next 12 months, better than the 11% envisioned for the S&P 500.

Not Out of the Woods: Reduced interest costs, of course, aren’t the only high-level economic factor on the minds of executives and investors. One risk for small-cap firms is that their lower margins, higher debt loads and attenuated supply chains are all highly sensitive to tariffs, which Powell said Wednesday could lead to a “one-time shift” in prices or cause “more persistent” inflation. For the time being, Bank of America and UBS are among the Wall Street heavyweights that foresee a Russell 2000 rebound. But even those who expect the market rally to broaden and include small caps, like Goldman Sachs, have cautioned, “there is limited scope for small-caps and other ‘lower quality’ stocks to consistently outperform,” which is a hint that you should diversify your portfolio.