Small Caps Need A Perfect Macro Mix To Keep Outperforming

Authored by Michael Ball, Bloomberg macro strategist,

The Russell 2000 has been outperforming its larger cap brethren lately. Continued leadership next year only makes sense if the economy threads a needle of growth and inflationary conditions.

Quant Insight’s Principal Component Analysis model, which attributes performance to macro factors, cuts straight to the point.

The Russell is increasingly behaving like a clean expression of two things investors want at the same time — stronger economic growth and easier Fed policy — and one thing it can’t afford — inflation, the model shows.

Positive sensitivity to rate-cut expectations and growth, negative sensitivity to inflation, is exactly what you’d expect for an index packed with higher leveraged balance sheets and less pricing power than than the large-cap S&P 500.

The reacceleration narrative is still driving the trade -- but it’s also the potential trap.

If growth shows up without inflation, the Fed stays in easing mode and small caps can keep running.

If growth shows up and inflation follows, the Fed’s risk management cuts are done, real yields stop falling and small caps lose one of their biggest tailwinds.

Further, if growth doesn’t show up at all, earnings optimism fades and the Russell is hit hardest. The conditions have to be just right.

JPMorgan’s macro research team says this goldilocks regime is possible.The group sees the current cooling in economic momentum giving way to a notable rebound in the first half of 2026, helped by front-loaded fiscal policy and a boost from the reopening of the federal government that should lift sentiment and job growth.

At the same time, they’re still looking for another rate cut from the Fed in January, but they’re not leaning into a long easing runway after that. That’s an awkward mix for the Russell — small caps need the growth impulse and the Fed to keep easing.

Goldman Sachs, meanwhile, is constructive on the near-term setup for the Russell, but sees it more as a first-half trade. Their economists forecast above-consensus US growth in 2026 paired with below-consensus inflation and two more 25-bp cuts.

That’s a good cocktail for small caps because it hits the Russell’s two key positive sensitivities without lighting up the biggest negative factor.

Goldman also highlights in a recent note that futures positioning is still light versus prior small-cap rallies, even if short interest is structurally higher than that for the S&P 500.

But they warn valuations are already above average and consensus earnings growth estimates may be too high.

That’s why the cleanest takeaway for 2026 might be less about small-cap beta and more about dispersion.

Goldman stresses the Russell’s dispersion is more than twice that of the S&P 500.

Fiscal cross-currents, incremental AI adoption, other tech developments and an improving M&A backdrop can all create idiosyncratic winners even if the index as a whole struggles to beat the S&P 500.