Small Caps Outperform on Expected Rate Cuts

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

The S&P 500 reached fresh all-time highs on Friday as softer than estimated inflation data reinforced investor bets on further interest rate cuts. Speculation that the monetary policy easing will help supercharge corporate earnings also pushed stocks higher.

In the aftermath of Federal Reserve rate hikes in 2022 and 2023, interest rate-sensitive parts of the economy have seen slower economic growth—think manufacturing, housing, Small Cap companies and lower- to middle-income consumers. Contrast that with Large Cap companies tied to the secular theme of artificial intelligence and higher-income consumers that are more interest rate insensitive. This has created a bifurcated economy, which has in turn led to a bifurcated market. Put simply, companies that are interest rate sensitive have seen little to no earnings growth versus less sensitive sectors that have seen earnings grow over the past few years.

Interest rate-sensitive Small-Cap stocks led the charge last week. In a sign that lower interest rates could help broaden future economic growth, which would serve to broaden earnings and market growth, the S&P 600 index was up 3.22 percent, outpacing the Large-Cap S&P 500’s 1.93 percent.

Small-Cap outperformance is a noticeable departure from the Large-Cap dominance that has come to define the past several years, as an increasingly smaller concentrated subset of stocks has done the heavy lifting in markets in U.S. equity markets. Since 2022 the S&P 500 has returned 24 percent annually versus 10.9 percent for their Small-Cap counterparts.

However, the S&P 500’s advance over the past couple of years has been driven by a historically narrow subset of stocks. For example, in 2023 only 28 percent of the companies in the S&P 500 outperformed the return of the index, while in 2024 a slim 32 percent outperformed the index. In data going back to 1973 the average is 48 percent.

We note this narrowing of the markets is not uncommon, as it often happens during periods of time when the Fed has been raising interest rates, such as 1973, 1980, 1990 and 2020. However, the past two years are tied for the narrowest years on record with 1998 and 1999. Back then, it was the dot-com boom coupled with corporate Y2K spending that kept a bifurcated economy pushing ahead. Today the artificial intelligence frenzy has fueled significant outperformance in that segment of the economy and market, while other sectors have lagged. In both cases, markets became deeply segmented as winning stocks produced outsized earnings growth given their relative economic insensitivity and ties to the leading technology of the era.

We continue to believe that both the economy and markets will broaden, much as they have in the aftermath of every narrow market over the past 52 years. Investors appear to be positioning for a broadening as lower interest rates alleviate stress on the interest-sensitive parts of the economy and markets.

As the Fed’s October 28-29 meeting fast approaches, investors are betting heavily that the cooling job market will fuel additional rate cuts. Markets are currently pricing in a 100 percent chance of a 25-basis-point cut later this week as well as another one in December.

It’s not just short-term rates that have fallen over the past few months; it has also occurred across the Treasury yield curve. The two-year treasury has fallen from 4.24 percent to start 2025 to 3.48 percent to end the week, while the 10-year has dropped from its peak of 4.79 percent in mid-January to end this week at 4 percent. These moves have accelerated in recent weeks, especially in the aftermath of the July jobs report that saw significant downward revisions to prior-month jobs reports, which caused markets to price in future rate cuts. Since the release of that jobs report, Small-Cap stocks have outperformed their Large-Cap counterparts by 3 percent.

We expect this relative outperformance to continue in the coming years, given the relatively cheap valuations of Small Caps relative to Large Caps coupled with expectations of better earnings in the days ahead. We also note that we expect the benefits of AI to spread throughout the U.S. economy and help companies across the spectrum improve their margins and profits, much like the period post-1998 and1999.

While we expect better days ahead for the broader economy and markets, the question remains if there will be an economic and market hiccup along the way. While falling Treasury yields are a positive, they likely also reflect worries that the labor market is weakening, which (at least historically) has been a sign of potential economic weakness.

Whether more good news or bad news lies ahead, maintaining a well-diversified portfolio is the key to remaining prepared for all economic outcomes.

Wall Street wrap

Softer inflation reinforces rate cut expectations: September Consumer Price Index (CPI) inflation data from the U.S. Bureau of Labor Statistics (BLS), which was delayed as a result of the shutdown, came in softer than expected on Friday despite ongoing worries about the effects of higher tariffs.

CPI and core inflation, which excludes more volatile food and energy costs, came in a tenth of a percentage point lower than anticipated, with monthly increases of 0.3 percent and 0.2 percent, respectively. On a 12-month basis, headline CPI rose by 3 percent, slightly faster than the 2.9 percent seen in August, while core inflation also rose by 3 percent, marking a slowdown from last month’s 3.1 percent.

Goods inflation rose 0.2 percent in September after August’s 0.3 percent, while the year-over-year pace remained at 1.5 percent from last month. We note that this level has not been seen since the period spanning June 2011 to May 2012 (excluding the COVID-impacted months of December 2020 to May 2023). Most importantly, goods have functioned as a source of disinflation for much of the past 25 years, refraining from exceeding the current 1.5 percent year-over-year level from April 1996 all the way to August 2009.

Within goods, car prices fell, with new vehicle prices up just 0.2 percent compared to 0.3 percent in August. Used car and truck prices fell by 0.4 percent in September, a significant turnaround from August’s 1 percent increase. The impact from tariffs was apparent in other categories, however. Apparel prices rose 0.7 percent in September on the back of another substantial 0.5 percent gain in August. Household furnishings, which rose to the category’s highest level since mid-2023, increased by 3 percent on a 12-month basis. Audio and video equipment rose 2.1 percent, the highest since 2021.

Services inflation, which excludes energy services, also came in cooler than expected, gaining 0.2 percent in September versus August’s 0.3 percent. This was likely aided by softer shelter inflation, however, as “supercore” services inflation, which excludes housing costs, increased by 0.35 percent month to month.

Despite inflation remaining notably above the Federal Reserve’s 2 percent target, the softer than expected CPI report has reinforced market expectations of an interest rate cut at the Federal Reserve’s upcoming policy meeting and increased the likelihood of further easing in December.

Inflation remains a main concern for consumers: While overall CPI remained relatively tame in the month of September, consumers continue to express pessimism with regards to inflation according to the University of Michigan's Surveys of Consumers which fell to a five-month low of 53.6 as both current conditions and expectations faltered in the month October. Interestingly, the university’s Current Economic Conditions Index fell to 58.6, down from 60.4 in September in its lowest number since June–August 2022. Aside from that two-month period, the index has never dipped so low since the Global Financial Crisis in October and November 2008.

Consumers assessment of future intermediate to long-term inflation continued to be a prime concern with the five- to 10-year median CPI rising to 3.9 percent in September from 3.7 percent the previous month, continuing its upward climb from July’s 3.4 percent. Aside from the period of March–June earlier this year, when the figure peaked at 4.4 percent in April, this is the highest reading since May 1992 when inflation was continuing to rise from 1980s-era highs into more stable territory. This shows that many consumers think inflation could potentially become a more permanent fixture in the U.S. economy.

Nonetheless, inflation remains a key concern for consumers, with 45 percent of respondents stating that their personal finances were negatively impacted by high prices, the highest reading since August 2024. Similar concerns arose for large purchases as well: “For large household durables, buying conditions worsened this month as a rising share of consumers negatively referenced prices or tariffs. Buying conditions for vehicles are more than 20% below a year ago, with 39% of consumers citing high prices,” the surveys noted.

Economy shows signs of strength, but tariffs loom overhead: “Flash” preliminary data from the S&P Global Purchasing Managers Index, a monthly economic indicator based on a survey of purchasing managers in various sectors, released on Friday reflected a strong start to the fourth quarter despite the ongoing government shutdown. The composite index, which measures activity across manufacturing services, edged up to 54.8 in October from 53.9 in September, reaching its fastest pace since July and signaling an acceleration of growth beyond the third-quarter average. Any number above 50 signals expansion.

S&P Global’s index of service companies reached a three-month high of 55.2 in October from 54.2 the previous month as new order inflows rose at the highest rate this year so far. Service providers reported signs of improving U.S. demand, though exports of services fell.

S&P’s manufacturing index inched up to 52.2 from 52.0 in the prior month as production volumes rose for a fifth consecutive month and factory output expanded at its highest rate since August amid an influx of new orders. That growth was limited to the domestic market, however, amid a sharp drop in exports to markets such as China and Europe, which many companies blamed on tariff policies.

Both manufacturing and services companies struggled to balance rising input costs with slower demand. “Firms across both manufacturing and services often reported difficulties passing higher costs on to customers in the face of subdued demand and intense competition,” the report noted.

Looking ahead, expectations about U.S. business activity in the coming year fell to one of the lowest seen over the past three years, with respondents citing tariffs and broader political uncertainty as key concerns. Meanwhile, employment rose for the tenth time in the past 11 months as the rate of job creation improved from September’s recent bottom, but the pace of job creation remained weak—particularly in manufacturing—as worries over higher levies weighed on hiring practices.

“The survey data [is] consistent with the economy expanding at a 2.5 percent annualized rate in October after a similar rise was signaled for the third quarter,” said Chris Williamson, chief business economist at S&P Global Market Intelligence. “However, business confidence in the outlook for the coming year has deteriorated further and is at one of the lowest levels seen over the past three years as companies worry about the impact of policies, most notably tariffs.”

Existing home sales rise: Existing home sales increased by 1.5 percent month over month in September to a seasonally adjusted annual rate of 4.06 million, according to the National Association of Realtors latest Existing-Home Sales Report. The uptick followed the Fed’s decision to cut interest rates, which has helped boost consumer confidence alongside slightly falling mortgage rates last month.

“As anticipated, falling mortgage rates are lifting home sales,” said NAR Chief Economist Dr. Lawrence Yun. “Improving housing affordability is also contributing to the increase in sales.”

The report also reflected a 1.3 percent increase in unsold inventory to 1.55 million units, representing 4.6 months’ supply. “Inventory is matching a five-year high, though it remains below pre-COVID levels,” Yun added. “Many homeowners are financially comfortable, resulting in very few distressed properties and forced sales. Home prices continue to rise in most parts of the country, further contributing to overall household wealth.”

The week ahead

Tuesday: The Conference Board publishes the Consumer Confidence Index at 10 a.m. EST. The index fell 3.6 points in September to 94.2, down from 97.8 in August, its lowest level since April, as consumers took note of slower labor conditions. The Conference Board’s much-watched labor differential fell for the ninth consecutive month. As we’ve often noted, the labor differential has an inverse correlation to the national unemployment rate, meaning that a further decline could foreshadow a rise in unemployment in the coming months. We will be watching to see if this trend continues and how it impacts the labor market.

Tuesday/Wednesday: The Federal Open Market Committee (FOMC) will convene over two days, October 28 and October 29, 2025. At these meetings, the committee reviews economic and financial data and decides whether to adjust the federal funds rate, which influences borrowing costs, credit availability and overall economic activity. The Fed is widely forecasted to reduce the federal funds rate by 25 basis points, from the current range of 4–4.25 percent to 3.75–4 percent, amid softer employment data and moderate inflation pressures.

Wednesday/Thursday: Five of the “Magnificent Seven” tech companies will publish third-quarter earnings this week, holding a major effect on the market due to how much of the S&P’s total earnings and market cap they occupy while lending valuable insights into the state of today’s bifurcated market. Alphabet, Meta and Microsoft will report on Wednesday, while Amazon and Apple will report on Thursday.

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