Mid-year outlook: North American small-cap equities

This article was written by Bloomberg Intelligence Chief Equity Strategist Gina Martin Adams and Senior Equity Strategist Michael Casper. It appeared first on the Bloomberg Terminal.

The Russell 2000 is still sharply discounted, yet catalysts remain scarce for the gauge to rerate higher — though easing trade tensions and lower rates are the most obvious possible sparks that could ignite some rally. Our Fair Value Model hints that the index’s multiple still has some room to rise based on rate consensus, but anemic macro forecasts are still driving a disconnect between the regression’s implied growth and bottom-up consensus — the former remains concerned about the weight of trade tensions on the US economy, while the latter appears to expect a swift resolution to tensions. Credit markets continue to sound an all clear, though rising distress in energy is worth watching.

Our latest sector rotation model favors utilities, financials, tech and industrials.

Three keys for 2025: US small-cap equities

Small-cap upside is in view, but all-time highs are a stretch

Based on rates consensus, small-cap stocks are a tad undervalued, allowing upside above 2,300 even if anemic macro consensus is right and just 1.3% sales growth emerges over the year ahead. Though bottom-up consensus is for a 5% top-line gain, significant economic acceleration would be necessary to achieve that run-rate — most likely as a result of significantly easier monetary policy. If recession emerges, downside to 1,587 is possible, based on the average economic contraction.

One step forward, two steps back for small-cap macro indicators

Economic cues for small-cap stocks were brightening into 2025 — the Federal Reserve was paring back rates, the yield curve was uninverting and ISM manufacturing touched expansion for the first time in over two years. But the trade war put an end to the improving trends, and now the signals that matter most for the size are mixed at best. Narrow high-yield spreads remain the strongest show of confidence, yet their retreat from peaks back to 2010-19 cycle lows hints that the onus is now on fundamentals, not sentiment, to drive further small-cap recovery.

The Fed isn’t riding to rescue small caps’ rangebound multiple

Small caps rapidly priced in a Fed easing cycle in late 2024, but the trade war and the specter of resurgent inflation have made the Fed’s path uncertain. At 1.27x — from a high of 1.52x earlier in November — multiples have some room to claw back to 2018’s high (1.45x), but that was when the federal funds rate was climbing to 2.4%. The current dot plot long-term forecast for rates is at 3%. With that 2018 multiple peak marking the high-water mark outside of the pandemic’s 0% rate environment, it might be a stretch for valuations to climb meaningfully higher without an assist from fundamentals.

However, additional slowing in the Fed’s balance sheet runoff since April could at least support multiples, but the small-cap gauge’s largest reratings generally occurred as the balance sheet was expanding.

Manufacturing just can’t gain footing to support small caps

US manufacturing has been mostly stuck in contraction territory since 2022 — the longest stretch without a sustained recovery since the Global Financial Crisis — causing the Russell 2000 to struggle to keep up with the less economically sensitive S&P 500. Since 1979, there have been 12 distinct periods where ISM manufacturing fell to at least a 47 handle. The Russell 2000 led the S&P 500 in the year after 10 of those lows, with one period of underperformance following 1996’s bottom, just as tech’s dot-com bubble began heating up. The other was after the June 2023 low. ISM fell back to 48.5 with May’s reading, down from 50.9 in January.

The Russell 2000 has gained a median 16% in the year following an ISM return to expansion vs.14.3% for the S&P 500 back to 1980.

Narrow high-yield spreads hint sentiment recovery is over

High-yield option-adjusted spreads are tight vs. history, suggesting scant signs of financial-market stress and hinting the early sentiment recovery off April’s lows may be past. Now, it will be on fundamentals to drive gains. High-yield OAS spreads reached a 583-bp peak by July 2022 — surpassing the apex associated with the correction in late 2018 (537 bps). Yet, despite bumps from the March 2023 bank crisis and the 2025 correction, it’s at 3% — below any point in the 2010-19 cycle.

Excluding the 2008 financial crisis OAS top, the Russell 2000 gained an average 32.2% in the year following each major crest in high-yield spreads last cycle (2010, 2011, 2016, 2019), and led large caps in three of four instances. This dynamic hasn’t played out post-pandemic, with small caps trailing by 3,353 bps since the July 2022 high.

Flat yield curve fails to signal all-clear for small-cap value

The yield curve isn’t giving small cap value much of a tailwind, and consensus expects very little steepening over the next year. The three-month to 10-year curve has been 0.71 correlated to the relative performance of value over growth, lending credence to the theory that value outperforms in the initial phases of recovery when the curve steepens the most. The curve has reinverted, but consensus expects it to turn positive by next quarter.

Historically, this curve led the start of all NBER recessions by an average of 340 days — with two false positives in 1966 and 1998 — and began steepening before every contraction except 1980. Stronger GDP growth and higher inflation forecasts are usually reflected in a wider yield-curve spread, providing a fundamental link to the more economically sensitive value share performance.