Small Caps Poised to Benefit from Rate Cuts

Over the past several years, small cap equities have dealt with a policy backdrop defined by aggressive rate hikes and tightening financial conditions. Historically, small cap companies—which are more reliant on floating-rate or shorter-term debt and domestically oriented—have tended to lag in high-rate environments but outperform once borrowing costs decline.¹

Historical data show that when interest rates are at or below 4%, small cap value stocks outperform large caps by an average of just over 2% annually. In contrast, when rates rise above 4%, we see small cap lag by over 6% annually.²

This dynamic underscores how rate regimes can shape performance across the equity landscape. Small cap companies, which tend to be more leveraged and rely more heavily on short-term borrowing, often face greater pressure when financing costs rise. Conversely, when rates stabilize or begin to decline, improved access to capital and stronger operating leverage can fuel meaningful recovery. 

At the end of the third quarter, valuations across the small-cap universe appear compelling relative to historical averages. The Russell 2000 Value Index traded well below historical average with a forward price-to-earnings (P/E) ratio of roughly 14x, compared to roughly 25x for the S&P 500 Index.³ These lower valuations may offer a wider margin of safety should monetary policy continue to ease further.⁴

As the Federal Reserve has begun to cut rates, with the potential for further cuts, easing credit conditions and stronger domestic demand could benefit small caps. The combination of discounted valuations and historical interest rate sensitivity highlights the importance of maintaining selective exposure to small cap equities within a diversified portfolio.