Small-cap U.S. stocks are on track to conclude one of their most robust first-half performances in decades. However, this current surge in small-cap stocks is not a typical rally led by traditional, economically sensitive sectors, as seen in the past.
Mirroring the logic of the large-cap market, the core driver of this small-cap advance stems from the massive build-out of artificial intelligence infrastructure. AI capital expenditure is radiating out from leading tech giants to a vast network of upstream and downstream supporting suppliers.
Investors believe that, provided interest rates remain stable, the small-cap rally has the potential to broaden beyond the technology sector and continue across the wider market.
The Russell 2000 Index has gained over 21% year-to-date, positioning it for its best first-half performance since 1991. This marks a powerful reversal for an index that had underperformed large-cap stocks for many years prior.
Where to Begin
Amy Zhang, a portfolio manager at Alger Funds, stated, "This rally combines both valuation recovery and fundamental improvement. The valuation gap between large and small caps was previously enormous. Concurrently, the fundamentals of small-cap companies have been steadily improving, which is the core reason this rally can continue to broaden."
Semiconductor and semiconductor equipment companies have emerged as the biggest winners, clearly demonstrating how the AI investment boom is transmitting across the entire market. Among the top 50 performing stocks in the Russell 2000 this year, 16 are chip-related firms, including Aehr Test Systems, Aecon Group Inc., and Methode Electronics, Inc., all of which have seen their share prices surge over 400%.
These small and mid-sized manufacturers are not in direct competition with industry giants like NVIDIA Corporation. Instead, they are achieving growth by capitalizing on the expanding demand across the entire AI supply chain. As chipmakers and cloud service providers ramp up investments in AI infrastructure, upstream supporting companies in semiconductor equipment, components, and network connectivity solutions continue to benefit, with many smaller-cap firms experiencing significant revenue and profit growth.
Manager Zhang noted, "The current rise in small caps is heavily tied to the AI industry's tailwinds. AI capital spending is trickling down from large-cap tech leaders to small and medium-sized suppliers. For small-cap companies, the elasticity of revenue and earnings growth is further amplified."
Beyond AI: Broader Tailwinds
While AI is the core catalyst for this rally, strategists argue that multiple fundamental tailwinds are collectively supporting the small-cap rebound, providing a foundation for a sustained bull run.
Adam Turnquist, Chief Technical Strategist at LPL Financial, said, "It's quite impressive to see small caps leading with such strength in a bull market dominated by large-cap tech stocks. These small-cap holdings are heavily concentrated in the semiconductor and tech hardware sectors, and when coupled with their own strengthening fundamentals, they have offset the downward pressure from high interest rates."
Data from LPL shows that the consensus earnings growth estimate for Russell 2000 constituents in 2026 has been revised up from 23% at the start of the year to 38%, reflecting market confidence that profit growth is spreading from leading tech firms to smaller companies.
Turnquist also listed several catalysts that could support continued small-cap strength: their higher sensitivity to U.S. domestic economic conditions; rising expectations for mergers and acquisitions in the healthcare and biotech sectors; and various tax incentive policies encouraging companies to expand capital expenditures.
Interest Rate Risks Remain a Concern
High interest rates, which suppressed small-cap stocks for years, remain the most significant potential threat to the current rally.
The Federal Reserve's policy meeting is scheduled for July 28-29. Data from the CME FedWatch Tool indicates the market is pricing in about a 30% probability of a rate hike at that meeting. By September, the probability of at least a 25-basis-point hike exceeds 60%.
Compared to large-cap firms, small and mid-sized companies generally have a higher proportion of floating-rate debt and greater refinancing needs, making them more vulnerable to rising borrowing costs. Analysis by Bank of America suggests that for every 25-basis-point hike by the Fed, the operating profits of Russell 2000 constituents could decline by approximately 2%.
Bank of America strategists noted in a report, "Small caps carry the highest refinancing risk. Rate hikes could dampen expectations for an acceleration in their fourth-quarter earnings and simultaneously weigh on overall market risk sentiment."
Despite this, most investors believe the current tightening cycle is nearing its end. The cumulative 500 basis points of rate hikes from March 2022 to mid-2023 represent one of the most aggressive tightening cycles in decades.
Manager Zhang concluded, "Inflation and interest rates have likely peaked. The headwinds that have suppressed the market over the past five years are about to fade and will gradually transform into market-supportive tailwinds."
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