Federal Reserve rate cuts bring back focus on small-cap stocks, ushering in a new wave of growth in the "post-giant era."

During most of the record-breaking surge in the US stock market, small-cap stocks seemed to be on the sidelines, especially during the strong rally in the benchmark S&P 500 index this year, which has repeatedly hit new highs. The small-cap benchmark Russell 2000 index has not been able to continuously set new highs like the S&P 500 index. Now, under the massive push of the continued heating up of the Fed's rate cut expectations, the market's "animal spirits" have fully returned, and they have finally briefly joined this investment feast and almost put an end to the period of underperformance against the S&P 500 index since the outbreak of the COVID-19 pandemic. During Wednesday's US stock market trading session, the Russell 2000 index rose as much as 2.1% to 2453.36 points on Wednesday, crossing its historical closing high since November 2021 for the first time, before giving back some of the gains and falling back from that level. The index eventually closed up 0.2%. Although the index has not yet surpassed its historical high set in November 2021, the brief surge after the Fed announced a 25 basis point interest rate cut, along with the recent outperformance against the S&P 500 index driven by Fed rate cut expectations, is enough to show that the market is increasingly favoring small-cap stocks in the context of rate cuts. Almost successfulThe Russell 2000 index briefly surpassed its historical closing high before giving back the gains The Fed's long-awaited rate cut move, which was already 100% priced in by the market, pushed the Russell 2000 index higher, despite a lower close for the broader US stock market that day. After the Fed policymakers decided to cut the benchmark interest rate by 25 basis points early Thursday morning Beijing time, the FOMC monetary policy dot plot showed that the Fed preliminarily plans to cut rates two more times remaining in the year, after facing strong pressure from the Trump administration for rate cuts for months. The Fed's first rate cut in nine months was undoubtedly in line with market expectations regarding the magnitude and timing of the move. The most focused FOMC dot plot suggests that the median interest rate forecast implies a total of three rate cuts from the Fed this year, one more than the previous dot plot, with an additional rate cut expected next year. After the Fed announced the rate cut decision, Nick Timiraos, the famous Wall Street Journal reporter known as the "mouthpiece of the Fed," wrote that concerns about a slowdown in the job market overshadowed concerns about inflation, providing a reason for the Fed to slightly cut rates, and the Fed's policy stance is shifting towards a broader focus on employment market weaknesses. Furthermore, in its policy statement after announcing the rate cut decision, the Fed did not reiterate the previous statement that the US unemployment rate remains low, the labor market is strong, and inflation remains slightly elevated, but instead deleted the statement on a strong labor market and added expressions of slowing job growth and a slight rise in the unemployment rate, stating that job growth has slowed, the unemployment rate has slightly increased but remains low; inflation has risen slightly, remaining slightly elevated. This statement modification indicates that the Fed's new rate cut cycle is officially underway. The statement reiterates that the FOMC monetary policy committee of the Fed focuses on the two risks faced in achieving its dual mandate of full employment and price stability, while adding an assessment of increased downside risks to employment. The statement reads: "The Committee is closely monitoring the two risks facing its dual mandate and judges that the downside risks to employment have increased." The Russell 2000 index is poised to enter a trajectory of repeatedly hitting new highs and leading a market counterattack For investors who favor small-cap stocks, these past few years have been very challenging, as these stocks have not been able to break out of a potentially strong long-term bull market trajectory like the S&P 500 index and the Nasdaq 100 index since the end of 2022. However, after years of tough times, the "risk factor" seems to have made a comprehensive comeback, and thus these stocks, the riskiest in the market, are finally seeing increasingly strong long-term bullish momentum. With the market's increasing expectations of a rate cut by the Fed, the investment sentiment towards small-cap stocks is becoming more optimistic. Currently, the US capital market is showing a pattern of "overvaluation of large companies, undervaluation of small companies": a few tech giants have high valuations while most stocks are not overheated. In addition to the improvement in the macro environment and expectations of a turning point in monetary policy easing, investors are preparing for possible style rotations, moving from the hot but historically high-valued tech giants to the long-overlooked high-quality small and mid-cap stocks with strong fundamentals. The so-called "Magnificent Seven" of US stocks, which hold a high weight (about 35%) in the S&P 500 index and the Nasdaq 100 index, include Apple, Microsoft, Google, Tesla, Nvidia, Amazon, and Facebook's parent company Meta Platforms, and they are the core driving forces behind the repeated highs of the S&P 500 index. Undoubtedly, according to historical patterns, the beginning of a Fed rate cut cycle is first beneficial to small-cap stocks. If the Fed rate cut cycle officially kicks off and the US economy shows strong resilience in achieving a "soft landing," the momentum of US stocks is very likely to continue rotating into the mid and small-cap stocks that have been hit hard since the end of 2022, which from an investment theory perspective are extremely sensitive to rate expectations. Even a small rate cut is likely to increase their beaten-down stock prices and valuations, especially for high-quality mid and small-cap stocks with performance support. Therefore, according to some Wall Street analysts, the Russell 2000 index is likely to follow a trajectory similar to that of the S&P 500 index this year, repeatedly hitting new highs and leading a market counterattack. A study by the US Bank of America's Wall Street research team shows that under the macro background of the Fed's rate cut, the performance of mid and small-cap stocks may far exceed that of the seven tech giants and the wider market. The main logic is that mid and small-cap stocks are often very sensitive to the benchmark interest rates set by the Fed, relying heavily on floating rate loans, so a Fed rate cut background means a significant reduction in their long-standing debt burden, thereby potentially boosting profit margins and stock valuations. In the view of the US Bank strategy team, the "spring effect" of mid and small-cap stocks is stronger: the lower they were pushed down in the early stage, the greater the rebound potential later. The long-term forecast of US Bank shows that in the next decade, the annual return of small-cap stocks is expected to outperform that of the seven giants dominating the market. If the US economy avoids a recession in the next 12-24 months and interest rates enter a downward trajectory, then as the market enters the "post-giant era" (when the rising trend of the seven giants dominating the market gradually gives way to the high-quality mid-cap stocks that have been ignored for so long), mid and small-cap stocks may experience a "double rise" in profitability and valuation, and their cumulative excess returns are expected to significantly outpace those of large-cap stocks. "A few months ago, small-cap stocks seemed to be on their last legs," said Irene Tunkel, chief equity strategist for US stocks at BCA Research. "Small-cap stocks are indeed cheap and have long been neglected, but they have been building momentum for a strong rebound. Along with the expected relaxation of monetary policy by the Fed, the new tax cuts from the OBBBA, and more eye-catching earnings expectations, this rebound suddenly has strong momentum." One nearly brief yet new record has drawn a remarkable return mark for the Russell 2000 index. Since the low point in April, the index has rebounded by more than 36%, when the market was deeply fearful of Trump's aggressive "Liberation Day" tariff policy and expectations for a revival of small-cap stocks under the "America First" agenda were dashed. "The recent significant rebound of small-cap stocks aligns with the resurgence of risk appetite and market expectations of a possible three rate cuts by the Fed this year," said Doug Beath, global equity strategist at Wells Fargo Investment Research. Steven DeSanctis, a market strategist at Jefferies, pointed out that the macroeconomic background is very favorable for small-cap stocks, and the second-quarter earnings data for the small-cap sector have also exceeded market expectations. "The earnings of small-cap companies in the second quarter were quite good, exceeding our expectations, and the market expects that later this year or next year, the earnings growth of small-cap companies will outpace that of large-cap stocks and the 'Magnificent Seven'," DeSanctis said. Bloomberg Intelligence strategist Michael Casper said that small-cap stocks' revenue is gradually approaching that of large-cap stocks in the market, and total sales are expected to eventually surpass the peak reached in 2022, indicating that small-cap stocks still have further upside potential. "If the Fed's rate cut successfully stimulates a soft landing for the economy, the market's expectations for revenue may be too low, which could give the Russell 2000 index an opportunity to eventually outperform the market," Casper wrote in a report released on September 11. Rising expectations are expected to help fuel the small-cap stock rally The Russell 2000 index came close to ending its "drought of record highs" by the end of 2024, but soon reversed course due to concerns about tariffs. Since its last record in November 2021, other major US benchmark indices have hit dozens of new highs, especially the S&P 500 index has hit over 20 new highs this year, but the Russell 2000 index has consistently failed to hit new highs. In recent weeks, bullish momentum in the market has significantly increased, with strategists gradually turning bullish on small-cap stocks. led by David Kostin, the Goldman Sachs strategy team believes that rate cut expectations and a rebound in corporate earnings will broaden this record-breaking rally to areas like small caps that have been neglected for a long time. At the same time, Michael Wilson, chief equity strategist at Morgan Stanley, pointed out that there is still considerable room for catch-up in rate-sensitive sectors like small-cap stocks. After Fed Chairman Powell sent a dovish signal at the August Jackson Hole meeting, Bank of America and UBS Group also joined the camp of long-term bulls on small-cap stocks. "I really think the 'animal spirits' are starting to pick up," DeSanctis said, noting an increase in merger activity as the market has moved beyond most tariff concerns and pessimistic narratives, and as relaxed regulation begins to have a positive impact. "There's also more secondary IPO activity. Overall, the uptick in capital market activity is good for small-cap stocks." Finally, the rising expectations for a rate cut are helping the Russell 2000 index to challenge its previously inaccessible historical high. Since about half of the constituents of this index are still not profitable, the rate cut provides a strong boost to this high-leverage group. "Interest expenses account for a high proportion of profits in small-cap companies, and lower short-term rates will help significantly alleviate this burden," said Beath from Wells Fargo Investment Research. While interest costs may decrease, Beath also warned that "lower-quality" small-cap stocks are more vulnerable to friction caused by Trump's tariff agenda, as their profit margins are thinner and their supply chain resilience is weaker. Therefore, Beath continues to favor US large-cap and mid-cap stocks, maintaining a cautious view on small-cap stocks. Small-cap stocks are undoubtedly basking in the continuing sunshine of bullish sentiment, but the trend of outperforming the broader market may still be questioned. Kostin from Goldman Sachs believes that small-cap stocks have room for better performance in the short term, but he does not think this trend will continue over the next 12 months. For Irene Tunkel, chief equity strategist for US stocks at BCA Research, small-cap stocks are still attractively valued, but "unignorable headwinds" persist. "The rebound is impressive, but many small companies are facing cost increases and profit margin contractions, which could make this rebound fragile," Tunkel said.