US small cap equities have delivered strong performance in the first half of 2026: The Russell 2000 index of small cap stocks returned 20.1% as of 30 June 2026, outperforming the S&P 500 index by 9.6 percentage points. While a prolonged period of outperformance would be needed to recover the underperformance since 2018 (Exhibit 1), the asset class may be at the start of a more favorable cycle.
The broader macro backdrop is supportive. Consumer spending and business investment in artificial intelligence (AI) have helped sustain robust economic activity despite energy headwinds. Increasing expectations of supply chain normalisation and the Strait of Hormuz re-opening also favor a risk-on market rotation, extending support to the small cap segment of the market. Fundamentals are also encouraging. Consensus estimates suggest robust earnings-per-share (EPS) growth for small caps that is significantly above expectations for large caps.
Earnings pivot from downgrades
Elevated earnings expectations are not new to small cap equities. Structurally higher potential growth, combined with greater operating and financial leverage, has historically meant that small caps tend to command an earnings growth premium relative to large caps over an economic cycle.
However, limited analyst coverage across the small cap universe sometimes creates more potential for upward or downward revisions as business conditions evolve. Over the past few years, downward revisions weighed on small cap stocks but more recent revisions have been relatively less downbeat, as the gap between this year’s EPS growth and last year’s has widened. Revisions for 2027 are more optimistic and are being revised higher, signaling a potential pivot in confidence in small caps’ earnings prospects (Exhibit 2).
Quality dilution over deterioration
Quality is often cited as a persistent challenge for small caps, as the proportion of loss-making companies in the Russell 2000 Index has risen from 23% pre-2008 to 43% in the latest 1Q 2026 earnings season. This is likely more of a reflection of market structure rather than a fundamental deterioration of aggregate quality in small cap indices.
Since the Global Financial Crisis, an increasing tilt towards prospects over profits in small cap initial public offerings (IPOs), alongside a longer holding periods by private equity funds has led to a lower supply of quality companies in the public market. These shifts in market structure have diluted the small-cap universe with less desirable names and reduced the small-cap premium at the index level. On a like-for-like basis, the quality picture appears more resilient. Among companies with comparable earnings data today and 10 years ago, 65% have shown improvement in earnings, which suggests quality dilution at the index level, instead of quality deterioration for small cap equities.
Moreover, these loss-making names are mostly concentrated in the healthcare sector, which accounts for over one-third of those in the Russell 2000 Index, while other sectors have relatively more manageable levels given more stable profits and resilient balance sheets.
As such, while aggregate quality may appear less favorable on the index, nuances in composition mask the underlying strength of the small cap universe, where fundamentals are more promising for stronger performance.
Debt is a double-edge dynamic
Interest rate sensitivity is another important distinction between small cap and large cap equities, stemming from two key differences: lower interest coverage (1.5x for small cap vs. 8.9x for large cap) and a greater share of floating-rate debt (41.5% for small cap vs. 18.0% for large cap). With a thinner margin for buffering financing costs and a larger share of liabilities that reprice with market interest rates, small caps are more sensitive to changes in interest rates. This sensitivity to interest rate changes is even more pronounced when policy rates are elevated and financial conditions are tighter, with small cap performance historically showing a deeper negative correlation to changes in interest rates during these periods (Exhibit 3).
The fall in interest rates from the 2023 peak has helped ease some of the pressure on small caps, with correlations also reverting to more neutral territory. That said, interest rate volatility is unlikely to abate in the near term, as uncertainty stems from geopolitical tensions and their inflationary spillovers, renewed labor market strength, and even changes in the US Federal Reserve’s policy communication style under a Warsh-led Federal Open Market Committee.
Small cap equities’ higher sensitivity to rates is increasingly becoming to a double-edged sword, whereby the incremental tailwind or headwind will firmly depend on ongoing geopolitics and economic developments.
From technology to data center demand
Beyond quality and rates considerations, sector composition is also often noted as another structural constraint, as small cap indices have meaningfully lower weights in technology than large-cap indices (Russell 2000: 18.5%, S&P 500: 38.6%).
However, as the AI buildout progresses, market strength is beginning to broaden from investment in AI hyperscalers and hardware manufacturers to industries that contribute to the surge in data centre construction, with industrials standing to benefit. While exposure to this opportunity set may be shared with private markets nowadays, small cap equities are still positioned to gain from an extension of this AI demand, given the relatively high weight in industrials (Russell 2000: 19.4%, S&P 500: 8.3%).
Investment implications
Following years of underperformance, valuations on US small caps continue to screen attractive, as measured by forward P/E ratios relative to large caps, especially for investors looking to extend their equity exposure in a constructive market environment.
Taking a holistic view, investors may be mindful of historical patterns of earnings disappointment, a decline in aggregate quality in small-cap indices due to the increase in companies focused on prospects rather than profits, and lower exposure to technology. However, earnings revisions are beginning to strengthen and the structural AI tailwind is starting to broaden toward industrials, which have a greater weight in small cap indices, helping to abate these concerns. The greater sensitivity to interest rates will need careful monitoring given shifting expectations for central banks this year, although stabilising geopolitical tensions may be an additional tailwind.
More importantly, these points reinforce the importance of selectivity. Return dispersion within small caps remains substantially wider than in large caps. An actively managed strategy with a fundamentally driven process and a robust risk management framework thus becomes even more meaningful for this asset class in unlocking potential alpha.