Small Caps Gain Momentum Amid Lower Rates

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.

Last week brought further signs of an economic broadening, continuing the theme over the end of 2025 and into the first week of January of investors increasingly rotating into Small-Cap stocks and more economically sensitive areas of the market.

The S&P 600 index of smaller, more interest rate-sensitive companies hit a new all-time high last week of 1574.84, surpassing its November 2024 record of 1544.66, as economic data pointed to cooler than expected and resilient consumer spending, pushing investors beyond the “Magnificent Seven” tech stocks and into more cyclical areas of the market.

While still running above the Federal Reserve’s 2 percent goal, the Consumer Price Index rose 2.7 percent in December, the same year-over-year increase as in November. Core inflation, however—which excludes more volatile food and gas prices—rose 2.6 percent over the past 12 months, coming in below the median forecast for 2.8 percent.

The rotation into Small Caps comes as parts of the economy previously weakened by higher interest rates have begun to find relief following the Federal Reserve’s three quarter-point cuts to its benchmark last year. Expected fiscal policy tailwinds, including the potential for higher tax rebates under the One Big Beautiful Bill Act, have also led investors to begin diversifying beyond Large Caps. (Read our Quarterly Market Commentary for a deeper dive into how the economic landscape is changing.)

The arrival of the Fed’s Beige Book showed that U.S. economic activity increased at a slight to modest pace in December, an improvement from prior reports with gains in consumer spending reported across districts. Furthermore, the percentage of small business owners surveyed by the National Federation of Independent Business in December who said they expect better business conditions rose nine points from November to a net 24 percent, the highest reading since August, in another sign that the economic landscape is improving.

Nevertheless, enduring signals of a tight labor market—initial jobless claims for state unemployment benefits dropped by 9,000 to a seasonally adjusted 198,000 for the week ended January 10—have led investors and monetary policymakers alike to proceed with caution, reinforcing the Fed’s “wait and see” approach when it comes to interest rates.

Optimism surrounding the lower cost of borrowing and the possibility of a broader economy has in turn led to a broader market, as investors anticipate attractive valuation discounts between Small- to Mid-Cap stocks and their Large-Cap counterparts. The S&P 500 fell 0.38 percent for the week. On top of the S&P 600’s new milestone, the Mid Cap-heavy S&P 400 also hit a fresh all-time high of 3516.91. Year to date, Small Caps are up 7.07 percent versus the S&P 500’s 1.43 percent gain.

Stronger earnings growth is also helping fuel that broadening. From 2023 to 2025, the percentage of S&P 500 companies that outperformed the index was between 28 and 31 percent, a historically narrow amount and well below the long-term average of 48 percent. Over the last few months, however, the portion of outperforming S&P stocks has grown to 65 percent as more segments deliver fundamental bottom-line growth. We believe this broadening will only continue as greater AI adoption accelerates across industries, translating to solid gains beyond just Large-Cap tech stocks.

Investors have plenty to feel optimistic about in 2026 as the economy and markets continue to broaden. However, the U.S. economy and markets remain in a delicate balance as prolonged inflation and uncertainty surrounding the labor market continue to muddy the long-term outlook for monetary policymakers. Meanwhile, a U.S. Department of Justice probe into the Fed targeting Fed Chair Jerome Powell has raised bipartisan concerns over the independence of the central bank—particularly as the arrival of a new chair in May adds potential for a pro-growth shift in monetary policy. Finally, President Donald Trump’s declaration of 10 percent tariffs on eight European countries beginning in February—part of the administration’s push to make Greenland a part of the U.S.—could further complicate the economic picture.

Current deliberations by the Supreme Court over the legality of tariffs under the International Emergency Economic Powers Act and the upcoming November midterm elections also pose questions around the economy as the scales of power continue to shift in Washington.

While the political and economic climates are always shifting, your investment perspective doesn’t have to. The new year will bring a renewed focus on diversification as the economy and markets shift beyond concentrated indices and sectors.

We continue to focus on the intermediate to long term and believe that maintaining a well-balanced asset allocation is the key to outlasting short-term volatility. For a detailed look into how our strategy is built to weather unpredictability, take a look at our latest Asset Allocation Quilt.

Wall Street Wrap

Beige Book reflects uneven growth, continued bifurcation: The Fed’s December 2025 Beige Book painted the picture of modest growth, albeit at a cautious, uneven pace. It also highlighted the continued delicate balance and bifurcated state of the economy and markets as high-income consumers continue to dominate in terms of spending power.

Overall economic activity increased at a “slight to modest pace” in most regions, with eight of 12 districts reporting growth, three remaining unchanged and one reporting a slight decline. This reflects a modest acceleration compared with prior reports, which reflected flatter activity.

The labor market remained stable but soft at the end of 2025, characterized by sluggish hiring trends. Employment was mostly unchanged, with most hiring limited to backfilling positions rather than adding new jobs. Several districts noted continued use of temporary workers and reduced job mobility, signaling some cooling in labor demand. Wage growth remained moderate overall, consistent with the stagnant labor market.

Consumer spending power remained notably bifurcated, with higher earners supporting overall activity as price sensitivity curbed lower-income spending. Higher-income households spent on travel, luxury goods and services, while lower- and moderate-income consumers were more cautious or cutting back on discretionary purchases.

Inflation remained sticky despite showing signs of moderating as businesses continue to deal with ongoing cost pressures. Tariff-related input costs and higher insurance and energy expenses arose as common themes across districts.

CPI inflation ends 2025 on a stubborn note: Inflation remained sticky overall in December, continuing to hover above the Fed’s 2 percent target and fueling expectations that the U.S. central bank will keep interest rates steady at its meeting at the end of January 2026.

Consumer Price Index (CPI) inflation rose 2.7 percent on an annual basis in November, matching the rate seen in November. On a monthly basis, prices increased by 0.3 percent. Core inflation, which excludes more volatile food and energy costs, rose 2.6 percent for the 12 months ended in December, slightly lower than economists' expectations of 2.7 percent.

Food prices rose 0.7 percent in December and 3.1 percent over the past year, the fastest monthly increase observed since September 2022. Housing costs increased 0.4 percent for the month and 3.2 percent annually, making it the largest contributor to the overall monthly rise in CPI inflation. Other notable monthly increases included the price of airline tickets (+5.2 percent), recreation (+1.2 percent), and medical care (+0.4 percent).

On the bright side, prices for used cars and trucks fell 1.1 percent, gasoline process fell 0.5 percent, and communication sector prices fell 1.9 percent.

Core goods prices, the category most affected by tariffs, stayed flat for the first time since May after climbing steadily.

Spending remained resilient in November: U.S. retail sales released last week from the U.S. Census Bureau showed solid momentum, with headline sales rising 0.6 percent in November to $735.9 billion, beating expectations and rebounding from October. Gains were broad-based across categories such as online retail, clothing and restaurants. Core retail sales also strengthened, underscoring continued consumer spending resilience heading into the end of 2025.

Small business owners remain cautiously optimistic: The National Federation of Independent Business (NFIB) released its Small Business Optimism Report last week, reflecting a slight increase in sentiment among small business owners at the start of 2026.

As Small-Cap companies are generally more sensitive to changes in interest rates than Large Caps are, the recent small business outlook has picked up as the lower rate environment begins to alleviate some bifurcation in the economy and markets.

In December, a net negative 3 percent of owners reported paying a higher interest rate on their most recent loan, down five points from November and the lowest reading since January 2021.

The Optimism Index rose modestly by 0.5 points to 99.5 in December, marking the second straight monthly gain and keeping the index above its 52-year average of 98. As previously mentioned, the main contributor to this rise was a sharp increase in the net percentage of owners expecting better business conditions, rising from 15 percent to 24 percent, the highest reading since August.

As optimism rose, uncertainty fell. The NFIB’s Uncertainty Index, which measures how unsure owners feel about future conditions, dropped seven points to 84, its lowest reading since June 2024.

Even as small business attitudes improve, the data shows that the market is still deeply segmented, highlighting the delicate balance the Fed must walks as it approaches monetary policy in the coming months. The outlook for small business sales cooled in December.

A seasonally adjusted net -8 percent of small business owners reported higher sales in the past three months compared to -9 percent in November. While still negative and historically weak, this shows improvement compared to 2023 and all of 2024, when this figure fell into the negative mid-teens to -20.

Meanwhile, sales expectations pulled back but remain fairly optimistic. The net percentage of owners expecting higher real sales fell by about five points from November to a seasonally adjusted 10 percent. Actual and planned prices also fell, with the net percentage of owners raising average selling prices falling four points from November to a seasonally adjusted 30 percent. These price increases remain well above the historical average of a net 13 percent, showing there are still inflation pressures that could reignite.

Other components, including plans for hiring, capital expenditures and real sales growth, also edged down. Taxes remain a top concern, with 20 percent of small businesses citing them as their most important problem, the highest percentage since 2021, in a sign that policy costs are weighing on sentiment.

In December, a net negative 3% of owners reported paying a higher interest rate on their most recent loan, down 5 points from November and the lowest reading since January 2021. The average rate paid on short maturity loans was 8.4% in December, up 0.5 points from November’s lowest level since May 2023.

The Week Ahead

Thursday: The Bureau of Economic Analysis will release its Personal Income and Outlays report for October and November 2025 as the federal agency continues to work through data backlogs following the government shutdown. The report will contain key insights into the Personal Consumption Expenditures price index, the Fed’s preferred inflation gauge.

Friday: S&P Global will release U.S. flash Purchasing Managers Index data for January, offering an early glimpse into business activity, inflation and employment trends for the start of the year.

Separately, The Conference Board will release U.S. Leading Economic Index figures for October and November 2025 on Friday after a lapse in federal reporting following the government shutdown.

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