US small-cap equities: Time to shine after years in the shadows?

When most people think of the US equity market, their minds immediately turn to the megacap technology giants - Nvidia, Microsoft, Apple, and Alphabet - whose share price moves and stellar earnings growth often dominate the financial newswires. These companies have been the key drivers of large-cap index performance in recent years.

However, after a prolonged period of relative underperformance, the smaller end of the market has begun to stir. In August, the shares of US smaller companies, as measured by the iShares S&P 600 small-cap ETF, rose by 7.0%, outpacing the 2.0% gain in the iShares Core S&P500 ETF (1).

In this month’s commentary, we explore the forces behind this shift and consider whether the momentum in small caps can be sustained.

AI boom leaves small-caps behind

US small-cap stocks have significantly underperformed their large-cap counterparts for the last 10 years or so. However, the performance gap has widened sharply since the launch of ChatGPT on 30 November 2022, which triggered a wave of buying in stocks tied to artificial intelligence (AI). Since the release of ChatGPT, the S&P500 ETF is up around 65%, while the S&P600 ETF is up around 19% (2).

The gain in the US large cap index has in large part been driven by beneficiaries of the AI boom, most notably by Nvidia, which designs high-performance graphics processing units (GPUs) that power the training and deployment of large artificial intelligence models. Nvidia’s share price has risen more than tenfold since November 2022 (3), and with a current market capitalization of US$4.3 trillion makes up just over 7% of the large-cap index (4).

More broadly, JP Morgan note that the 30 or so AI stocks in the S&P 500 make up a combined 43% of the index, and these companies have driven almost all of the returns and most of earnings growth since the release of ChatGPT (5). However, doubts are starting to creep in regarding the AI boom.

Recently, several prominent industry figures, including Sam Altman of OpenAI and Alibaba co-founder Joe Tsai, have said that AI is in a bubble (6). In addition, there have been reports that Meta was planning to downsize its AI division (7), and a report by MIT found that despite US$30-40 billion in enterprise investment into generative AI, 95% of organizations are getting zero returns (8). Against this backdrop, it is hardly surprising that investors might seek to rebalance their portfolios away from concentrated bets in the tech sector.

The tailwind from lower rates

Alongside potential “push factors”, a number of “pull factors” have also drawn investors toward small caps. Following dovish comments from Fed Chair Jerome Powell in August, and disappointing non-farm payrolls data in recent months, expectations for interest rate cuts from the US central bank have increased.

Lower interest rates tend to benefit smaller companies disproportionately, as they are more likely than large firms with sizeable cash reserves to rely on floating-rate loans that become cheaper to service when rates fall.

In turn, reduced debt servicing costs boost the profits of small-cap companies. Moreover, lower borrowing costs make it cheaper for large companies or private equity investors to acquire smaller businesses, a factor that can boost the share price of smaller companies.

As a result of these various factors, experience suggests that small caps tend to outperform their large-cap counterparts during the 12 months following a Fed rate cut (9).

Attractive valuations

Relatively attractive valuations add to the appeal of US small caps. The high valuations investors place on the megacap tech companies (Nvidia trades on forward price-to-earnings ratio of around 40x) has meant that the large cap index is historically expensive relative to expected profits (10).

The forward Price to Earnings (P/E) ratio of the S&P500 is currently around 22x. In contrast, that of the S&P600 is just under 16x. As a result, small caps are trading at a roughly 30% ‘discount’ to large caps, a level approaching the cheapest relative valuation seen in over 20 years (11).

However, attractive valuations alone do not guarantee stronger returns, and small caps face some notable headwinds. In particular, they could be disproportionately affected by the tariffs recently imposed by the Trump administration.

Large multinationals are better able to reconfigure supply chains in response to higher tariffs: for example, Apple shifted iPhone production to India when tariffs on Chinese goods rose. However, research from JP Morgan concludes that smaller companies face more concentrated supply chains, and therefore lack the flexibility of larger firms to quickly navigate varying tariff rates (12).

Moreover, smaller companies also have a greater dependence on China, which currently has a relatively high tariff rate of around 30% (13). As a result of these factors, smaller companies could end up facing a bigger increase in their import bill relative to larger companies.

However, as smaller companies generally have less pricing power than big companies, they are likely to have problems passing these costs on to their customers, with the result that profit margins could be squeezed. According to a recent survey by the Federal Reserve Bank of Atlanta (cited in the JP Morgan study), small firms expect to pass on about 54% of increased tariff costs via price increases this year, compared to 65% for larger firms (14).

Macro outlook key

The macroeconomic outlook will also be key in determining the performance of small cap stocks. Small caps tend to be more dependent on domestic US demand and are more cyclically-sensitive than larger companies.

Whereas US large cap indices are dominated by the tech sector (over one third of the index on one measure (15)), the small cap sector tends to have a greater weighting to industrials, financials, and consumer discretionary (16) i.e. sectors whose fortunes are more dependent on the ups and downs of the economy. Currently, investors are pricing in roughly 125 basis points of Fed rate cuts over the next year (17), while also assuming the economy avoids a major downturn (18).

This ‘goldilocks’ scenario could prove optimistic. So far, the US economy has held up well in the face of the Trump tariffs, and confidence amongst small businesses has recently risen above long-term average levels (19).

However, the recent softening in the US labour market -only 22,000 non-farm jobs were created in August - may portend broader cyclical weakness in the economy. If US Gross Domestic Product (GDP) growth disappoints and the economy turns down, the revenues and earnings of smaller companies are likely to be significantly impacted.

Conversely, persistently above-target inflation - the core Consumer Price Index (CPI) rose 3.1% year-on-year in August (20) - and elevated household inflation expectations (21) could make US policymakers wary of cutting rates aggressively. If interest rates do not drop as much as is currently priced in by the market, the expected relief on small companies’ debt servicing costs will prove more limited.

Small caps’ time to shine?

It is too early to say whether the recent rebound in US small-cap share prices signals the beginning of a sustained market rotation into the sector. Smaller companies are historically ‘cheap’ relative to their large-cap counterparts, but this is not a sufficient condition for a sustained outperformance going forward. And there are both risks and opportunities going forward.

Although current AI enthusiasm is concentrated on megacap tech, and has large-cap outperformance in recent years, broader adoption of the technology could meaningfully enhance the productivity and earnings of smaller companies in the years ahead.

The Trump tariffs could benefit smaller US companies by redirecting demand toward domestic producers and encouraging the reshoring of supply chains. However, for firms reliant on imported inputs, the impact may be less favourable. Concentrated supply chains and limited pricing power could leave small caps more exposed to margin pressures than their large-cap peers as import costs rise.

The trajectory of domestic demand and interest rates will be key drivers of US small-cap performance going forward. If the economy remains resilient at the same time as interest rates fall sharply, the earnings of smaller companies should improve, thereby supporting share prices.

There are clear risks on this front, but one might argue that growing political pressure on the Federal Reserve (see our commentary of August 2025 ), which results in loose monetary policy and keeps the domestic economy ‘hot’, could be good news for smaller companies, at least in the near term. All in all, given concerns about valuations and concentration in the US large-cap space, US small caps offer a source of diversification and are well-placed to benefit from potential market rebalancing.

As the companies in the S&P 600 small-cap index make up only around 3% of total US equity market value (22), small reallocations from megacaps could have an outsized effect on small-cap prices, potentially improving relative performance. Smaller US companies might never become household names like their large cap counterparts, but they are deserving of a place in investors’ portfolios nonetheless.

19 September 2025