CIO suggests why investors should stick with small-cap stocks despite their volatility. (Shutterstock)

Investors in US small-cap stocks have experienced sharp swings over the last few days. A higher-than-expected reading on US consumer price inflation in January led to more hawkish pricing of the extent, speed, and timing of Fed rate cuts. The Russell 2000 (an index of US smaller listed companies) fell around 4% on 12 February, its steepest one-day fall since June 2022. A day later, seemingly more dovish commentary from Fed President Goolsbee that reopened the possibility of deeper rate cuts (albeit with the market now expecting a first rate reduction in June, from March at the start of this year) helped drive a 2.4% recovery in the Russell 2000.

Investors holding small-cap stocks should be aware of their potential volatility, given these securities are typically less frequently traded than bigger companies and more sensitive to interest rate expectations.

But we believe small-cap stocks offer a way for investors to position portfolios for our base case as well as our upside scenarios given their interest rate sensitivity and low valuations. Our base case considers slower growth, falling inflation, and Fed rate cuts this year, likely starting in the second quarter, while our upside "Goldilocks" scenario considers Fed rate cuts in response to still-robust US economic activity and cooling inflation.

US small-cap stocks expected to see some of the largest gains from lower US rates. We think stocks of smaller US companies can complement core holdings in quality stocks over a tactical (6–12 month) investment horizon. Nearly half of the debt held by Russell 2000 companies (a well-followed index of US small-caps) is subject to floating interest rates (as opposed to around a 10th of debt following floating rates for US large-cap companies). This means US small-cap stocks could be beneficiaries of pre-emptive Fed interest rate cuts and lower US borrowing costs. US small-cap valuations are appealing, offering scope for catch-up if US growth holds up better than markets expect. For example, the Russell 2000 is trading at a roughly 53% discount to the Russell 1000 on a price-to-book ratio, versus a 10-year average discount of 32%.

Engagement stock strategies may benefit from their size bias. For sustainability-focused investors, ESG engagement equities may outperform in a “Goldilocks” scenario. This is because small- and mid-cap firms are overrepresented in such strategies—it is often easier to engage on sustainability criteria and boost profitability in smaller firms over larger ones. However, we would expect the main performance driver of this strategy to remain managers’ ability to drive improvement on environmental, social, and corporate governance factors that have a material effect on companies’ costs, revenues, and operational efficiency.