Small caps could be ready to go big

Long overshadowed by the gains made by megacap tech stocks, small caps are back in the sun. In August, the Russell 2000 increased for the fourth straight month, the longest such run since 2021. The small cap index's August returns exceeded the S&P 500's by more than 5%. This comes after a prolonged period of outperformance by large companies, led in particular by the Magnificent Seven. Might that leadership be about to change?

Even if tariffs bump inflation upward, many economists don't expect that to last - and the Federal Reserve seems ready to acknowledge this. It's unlikely Fed Chair Powell would have struck such a dovish note at Jackson Hole if he expected inflation to take off again, and today's weak jobs report has greatly increased the likelihood the Fed will lower rates in September. Rate cuts are traditionally bullish for equities in general and small caps in particular because the latter tend to rely more on floating-rate debt to finance their operations. This leaves them more exposed to changes in the interest-rate market but can make a rate-cutting cycle especially beneficial.

In addition, tax relief and deregulation should boost smaller companies' earnings. Notably, they could benefit from lower costs of compliance with government regulations. Furthermore, the One Big Beautiful Bill offers improved tax deductions for interest expenses, which should be particularly helpful as these businesses are often leveraged.

Biotech is the sector most sensitive to changes in interest rates. While these companies do not generally have leverage, they externally finance their business models - especially in the small cap space.

Another category that may benefit from lower rates is the IPO market, which has already almost reached last year's number (138 versus 150 last year). September is expected to be a robust month for IPOs.

Smaller companies can also reap rewards from advances in AI, which is beginning to democratize computing power by giving more access to robust models. This could help these businesses handle inflation pressures; use cases are emerging in biotech among other sectors. In particular, the health care sector may be poised to benefit as it could reduce costs. Estimates call for AI to drive savings of 10-20% of total hospital costs by 2050. That's a substantial amount for a country such as the US that spends a relatively high percentage of GDP (18%) on health care.

After a period when the lion's share of market returns came from a handful of the largest firms, we expect stock selection outside of the Magnificent Seven to matter more and more. Declining interest rates are likely to increase market breadth, potentially providing an excellent opportunity for small caps - some of the most innovative companies - to deliver impressive returns.