Why Small Caps Can Thrive in a Rate-Cutting Environment

In Q3 2025, small-cap stocks outperformed large-caps by more than 4%, helping narrow the year-to-date performance gap. As of the end of September, the S&P 500 is up 14.8% for the year, while the Russell 2000 Small Cap Index has gained 10.4%. As the Federal Reserve pivots toward monetary easing, small-cap stocks are poised to benefit disproportionately from rate cuts as their valuations remain attractive. Historically, these companies, often more domestically focused and financially sensitive, have outperformed their large-cap counterparts in the aftermath of rate reductions. The reasons are structural, cyclical, and deeply tied to the nature of small-cap balance sheets and sector exposure.

Many small-cap companies operate in capital intensive sectors such as industrials, utilities, and real estate. These industries rely heavily on external financing to fund operations, expansion, and infrastructure. When interest rates fall, the cost of capital declines, making it easier for these firms to invest and grow. For example, industrial manufacturers and building materials companies, often found in the small-cap universe, can accelerate production and capital projects when borrowing becomes cheaper.

Homebuilders are among the most rate sensitive small-cap players. Lower mortgage rates boost housing demand, benefiting builders who rely on loans. Rate cuts reduce loan costs, helping these builders regain market share and expand supply. Similarly, Real Estate Investment Trusts (REITs), especially those in residential and commercial properties, also see gains from lower financing costs and improved refinancing conditions.

Regional banks, which heavily populate small-cap indexes like the Russell 2000, have been under pressure from rising rates and inverted yield curves. Their portfolios, often concentrated in Treasuries and commercial real estate, suffered mark-to-market losses during the tightening cycle. Rate cuts can reverse this trend. Lower short-term

rates improve net interest margins, helping these banks stabilize and regain profitability.

“As the Federal Reserve pivots toward monetary easing, small-cap stocks are poised to benefit disproportionately from rate cuts.”

Utilities, though traditionally defensive, are capital intensive and carry significant debt loads. Many small-cap utilities have floating rate obligations, making them highly sensitive to rate changes. Rate cuts reduce interest expenses, freeing up cash flow for dividends and infrastructure upgrades.

Industrials, ranging from machinery to logistics, also stand to gain. These companies often operate with higher leverage and depend on cyclical demand. Lower rates can stimulate economic activity, boosting orders and easing debt burdens. For small-cap industrials with floating rate debt, even modest rate cuts can significantly improve margins.

One of the most compelling reasons small caps benefit from rate cuts is their exposure to floating rate debt. We estimate that roughly a third of small-cap debt is variable rate, compared to less than 10 percent for large caps. This means rate cuts directly reduce interest expenses for small-cap firms, improving profitability and cash flow. In a tightening cycle, this leverage is a liability. In an easing cycle, it becomes a tailwind.

While small caps carry more risk, higher leverage, economic sensitivity, and less diversified revenue, they also offer outsized upside in a ratecutting environment. With valuations still at a discount to large caps and monetary policy turning accommodative, we are seeing more compelling opportunities in sectors like homebuilding, regional banking, and industrials. Rate cuts don’t just lift the tide. They change the current, and small caps are well positioned to ride the wave. To learn more about how we integrate small caps into our investment strategies feel free to reach out for a conversation.