Rising interest rates are "strangling" small-cap stocks, and the Russell 2000's outperformance over the S&P 500 has shrunk to just 2 percentage points. Is capital about to return to concentrated AI trades?

Title context: Rising interest rates are "strangling" small-cap stocks, and the Russell 2000's outperformance over the S&P 500 has shrunk to just 2 percentage points. Is capital about to return to concentrated AI trades? Text: For most of this year, US small-cap stocks were an important destination for investors looking to diversify away from concentrated AI trades. But now, rising interest rates are putting a question mark over that strategy. The Russell 2000's year-to-date excess return over the S&P 500 has narrowed sharply from a peak of 11 percentage points in June to about 2 percentage points this week. The backdrop to this shift is that the market is repricing the Federal Reserve's policy path. As more rate-hike expectations are priced in and concerns spread that "the process of taming inflation will come with pain," the path ahead for small-cap companiesalready labeled the "riskiest stocks"is becoming increasingly fragile. "These largely cosmetic rate hikes are neither likely to impede earnings as the DRIVE behind S&P 500 gains nor likely to significantly curb inflation," Morgan Stanley Wealth Management Chief Investment Officer Lisa Shalett said in a note to clients. At the same time, she believes that "already weak areassuch as housing, regional bank lending and small capswill see growth moderate further." "This means the broadening of the stock market rally may fade, the market will once again return to a structural rally led by AI and the 'Magnificent Seven,' and the sense of economic imbalance will once again become prominent," she added. At present, the Russell 2000 has already fallen below its 50-day and 100-day moving averages, while the large-cap benchmark index continues to trade above support levels. Despite a rebound on Monday, the small-cap index remains 2% below its 100-day moving average. However, even after the recent weakness, the Russell 2000 is still on track for its best annual performance relative to the S&P 500 in a decade. "We have gone through a period of about a year and a half in which low-quality small caps outperformed, and this rally has already run ahead of itself," said Jill Carey Hall, equity and quantitative strategist at Bank of America Corp. She urged investors to "avoid more leveraged, rate-sensitive small caps against the backdrop of Fed rate hikes." The "graduation effect" of index rebalancing: high-quality companies are leaving If interest rates are the external pressure, then the annual index rebalancing is the internal structural predicament facing small caps, because outperforming Russell 2000 constituents are "promoted" to the Russell 1000, while laggards in the Russell 1000 are demoted. The outcome of this mechanism this year has been especially unfavorable for the small-cap index. Bloom Energy Corp. (BE.US), Credo Technology Group Holding (CRDO.US), Sterling Infrastructure Inc. (STRL.US) and TTM Technologies, Inc. (TTMI.US) together contributed two-thirds of the Russell 2000's gain through June 29, and on that day they were all moved into the Russell 1000 index. "The small-cap rally in the first half was more concentrated than usual," Carey Hall said of small-cap performance. Given the recent index rebalancing and the rising-rate environment, she expects mid-caps to outperform small caps over the medium to long term. In addition, several stocks that had previously benefited from the AI trade were also removed from the Russell 2000 index, including Credo Technology Group Holding Ltd. and Fabrinet (FN.US). "As the dual tailwinds of the rate environment and AI index constituents gradually fade, we continue to believe small caps face downside risk," said Stefano Pascale, strategist at Barclays PLC Sponsored ADR. He advised investors to hedge against the sharp impact of rate hikes on small caps by buying a Russell 2000 put option spread strategy. Stefano believes the turning point at which the performance gap between large and small caps began to narrow stemmed from the release of the July FOMC meeting minutes, which prompted traders to reprice rate expectations. Admittedly, for most of this year, optimism about strong earnings growth for the Russell 2000 overshadowed concerns about rising interest rates. Data compiled by Jefferies shows that small caps have just recorded their fastest quarterly earnings growth since 2022. JPMorgan's Andrew Tyler is among those inclined to be temporarily bearish on small caps. The bank's head of global market intelligence said in a note to clients on Monday that he maintains a preference for large caps because "small caps remain under pressure." Tyler noted that fund flows from professional money managers show the Russell 2000 faces greater risk than the S&P 500 and Nasdaq 100. The Russell 2000 rose 0.5% on Monday, trailing the S&P 500's gain and further narrowing this year's performance gap between small caps and large caps. "Small caps have clearly lost their market leadership position," said Jeff Jacobson, head of derivatives strategy at 22V Research.