Inside Markets — Small Cap

This week’s equity rally started with narrow leadership that broadened out as incrementally dovish Fed messaging moved through markets. Large cap AI data center themes still offer the greatest ‘convexity’ for investors, but Wednesday’s breakout in the copper/gold ratio could signal a brief period (1-2 months) of small cap outperformance. A breakout in the copper/gold ratio often precedes a cyclical recovery, which disproportionately benefits small cap companies that make up the Russell 2000 (RTY). The RTY also performs well when the Fed is easing because small cap companies tend to issue more floating rate debt than large cap companies. In our view, an extended period (9-12 months) of small cap outperformance requires policy easing that starts a cyclical recovery following an economic downturn or recession.

Note, the bullish fundamental outlook faces a test next Thursday when the June Jobs report is released. Non-farm payrolls additions >100,000 should be enough to keep the macro narrative intact. This level of payroll gains roughly equates to jobless claims <275,000. A bullish outlook also requires upside earnings revisions and favorable trade developments. This week we addressed all three pieces that we believe to be critical to the outlook, with reasons to feel confident each was trending in a positive direction. What surprised us this week was the dovish tilt in Fed messaging, which reinstated the ‘Fed Put’ that has been missing as a boon to equity markets since January.