The historic small-cap stock surge is entering a tougher phase as Goldman Sachs Asset Management warns that the period of effortless market gains has officially concluded.
Following the Russell 2000’s best first-half start since 1991, experts signal a stark cooling-off period ahead for smaller equities, forcing investors to reset expectations for the back half of the year.
The AI Tailwind Evaporates
While small caps recently posted stellar outperformance against their large-cap counterparts, Tim Urbanowicz, Head of Research at Innovator from Goldman Sachs Asset Management, cautioned that this rapid upward trajectory cannot be sustained.
A massive catalyst behind the recent boom was the artificial intelligence sector, with 40% of year-to-date gains driven entirely by AI infrastructure stocks capitalizing on rolling downstream money from massive hyperscaler spending.
However, a recent rebalance of the Russell 2000 index structurally altered this momentum, slashing the index’s critical AI infrastructure exposure cleanly in half—moving from 15% down to just 7%.
“A lot of the easy money, the bigger gains are going to be hard to come by,” Urbanowicz warned, pointing out that equity valuations have simultaneously become significantly less attractive than they were at the start of the year.
Shift to Rates and Growth
With the tech tailwind diminishing, Urbanowicz notes that the small-cap landscape must pivot from speculative momentum into a fundamental economic narrative. “This has to be a cyclical growth story and this has to be an interest rate story moving forward,” he explained.
Interest rates remain a critical make-or-break variable for these companies given the heavy volume of floating-rate debt on their balance sheets. On this front, Urbanowicz believes macro relief is coming because the broader market is actively “mispricing the Fed.”
While investors have priced in an additional interest rate hike by the end of this year due to tough central bank rhetoric, Goldman Sachs expects a softer macroeconomic reality to keep the Fed strictly on hold.
Small Caps Feel the Pressure
Federal Reserve’s decision on interest rates is imperative as the U.S. small-cap companies are carrying their heaviest interest burden in at least six years, as Interest expense currently accounts for 31% of EBITDA for Russell 2000 companies.
The largest exchange-traded fund tracking U.S. small-cap stocks, like the iShares Core S&P Small-Cap ETF (NYSE:IJR), tracking the S&P SmallCap 600 Index, has gained 19.48% this year, 5.60% over the last month, and 30.79% over the past 12 months.
While Vanguard Small-Cap ETF (NYSE:VB), tracking the CRSP US Small Cap Index, has returned 15.72% year-to-date. 3.57% over the month and 24.04% over the past year. Additionally, the iShares Russell 2000 ETF (NYSE:IWM), tracking the Russell 2000 index, was 19.42% higher YTD, 5.16% over the month, and 34.80% over the year.
Disclaimer: This content was partially produced with the help of AI tools and was reviewed and published by Benzinga editors.
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