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Investing.com -- Bank of America expects the Russell 2000 to extend its near-term gains as small caps benefit from the Federal Reserve’s dovish tilt and heightened rate sensitivity.
Chair Jerome Powell’s recent remarks at Jackson Hole have lowered the bar for a September cut, with markets now pricing in a roughly 90% probability.
“In the absence of major tariff news or other macro surprises, we think the Russell 2000 likely leads large caps in the coming weeks/through September, further supported by a likely shift to Recovery in our U.S. Regime Indicator if it rises again in Aug.,” BofA strategist Jill Carey Hall said in a note.
According to Hall, small caps’ refinancing exposure makes them more sensitive to Fed easing than in past cycles. Nearly half of Russell 2000 debt is short-term or floating rate, with more maturities looming compared to large caps.
BofA estimates the cumulative hit to net interest expense over the next five years at 35% of operating earnings, assuming 100 basis points of cuts next year, versus 42% if no cuts occur
This, Hall said, could fuel stronger-than-usual relative performance early in the cycle.
Earnings will be key to sustaining momentum beyond the initial rally. Small-cap profits beat expectations in the second quarter, pulling them out of a profits recession, but sales trends remain weaker than large caps and estimates for the back half of 2025 are still being revised down.
Guidance has improved, with small and mid (SMID) caps showing nearly twice as many companies guiding above consensus versus below, yet corporate sentiment remains below average relative to large caps.
In this backdrop, BofA recommends focusing on factor exposures within small caps that have historically outperformed during easing cycles.
“We recommend sticking with Quality and Value>Growth; Value is also the best-performing style in Recoveries,” Hall said.
She noted BofA’s U.S. Regime Indicator could soon shift from “Downturn” to “Recovery,” a phase that has historically favored small caps.
Seasonality may pose a challenge, however. September has typically delivered outperformance versus large caps, but October has been the weakest relative month on record for small caps.
Even so, BofA sees “many attractive opportunities” within SMID stocks, which are generally cheaper and provide greater alpha potential than large caps.
“We think picking your spots in SMID is especially important today and would continue to focus on names with less leverage/refi risk, stocks with strong margins (given tariff risks) and stocks with (+) revisions,” the bank concluded.