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Small-cap Russell 2000 has pulled back sharply from Nov

highs

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Trump's pro-growth policies seen helping small cap stocks

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Slower Fed rate cuts, tariffs could weigh on small caps

By Lewis Krauskopf

NEW YORK, Jan 17 (Reuters) - As investors seek assets

that will shine under a Donald Trump presidency, one corner of

the U.S. stock market expected to benefit from the Republican's

policies has been stumbling.

Shares of smaller U.S. companies have been under pressure,

with the small-cap Russell 2000 last week marking a 10%

correction from its November highs. The S&P 500, the

benchmark for large-cap companies, declined less than 3% in that

time.

Trump, who will be inaugurated for his second term on

Monday, is expected to back an agenda promoting domestic

economic growth, increasing the appeal of small-cap stocks.

But the group encountered a severe headwind in recent weeks:

the prospect of higher interest rates than previously expected,

which stand to raise borrowing costs that hit smaller companies

particularly hard.

"With more pro-growth policies, small caps tend to do better

in theory when the economy is stronger," said Keith Lerner,

co-chief investment officer at Truist Advisory Services.

"You almost have this tug of war," Lerner said. "On one

side, stronger growth should be good for small caps. On the

other side, high interest rates are negative."

Small caps and equities broadly won some relief this week

from an encouraging inflation report that calmed surging

Treasury yields.

The focus on small caps comes as investors look for "Trump

trades" that have room to run.

The overall stock market has given up some gains since

Trump's Nov 5 victory, when investors were enthused about his

pro-growth agenda benefiting equities broadly. The S&P 500 is up

3% since the election.

Some Trump trades continue to thrive. Shares of Tesla

, led by Trump backer Elon Musk, have gained over 60%

since Nov 5. Bitcoin, which is expected to benefit from a

friendlier crypto regulatory environment, is up over 40%.

Small caps, however, have pulled back. The Russell 2000

index surged nearly 6% on the day after Trump's win. Later in

November, it hit its highest closing level in three years. Now

the index is little changed since the election.

An expectation of fewer interest rate cuts this year has

dampened sentiment for small caps, with the Federal Reserve in

December projecting less easing as it raised its estimate for

inflation in 2025.

Treasury yields have surged. This week, the benchmark

10-year yield hit a 14-month high.

Smaller companies "tend to have greater debt loads...so not

getting the follow-through with lower interest rates is

something that sort of poured a bit of cold water" on hopes for

small-cap strength, said Yung-Yu Ma, chief investment officer at

BMO Wealth Management.

The Russell 2000 surged following Trump's 2016 election and

the index kept outperforming the S&P 500 in the year following

his first victory, rising 24% against a 21% for the large-cap

index.

Under Trump, the prospect of reduced regulations and

promotion of domestic business should benefit smaller companies,

whose businesses tend to be more U.S.-focused than larger,

multi-national corporations, said Sameer Samana, senior global

market strategist at Wells Fargo Investment Institute.

But while the group's outlook improves under Trump compared

to his predecessor Joe Biden, the incoming president's favoring

of tariffs could cause problems for smaller companies if they

disrupt supply chains, Samana said.

"There will be some things that are helpful under the Trump

administration... but there will also be some negatives," Samana

said.

Small-cap bulls are counting on some catch-up. The S&P 500's

nearly 50% gain over the past two years is more than double the

rise for the Russell 2000.

Still, small caps could face headwinds if interest rates

keep rising. Small-cap indexes tend to be more highly weighted

toward financials and industrials, sectors that are relatively

more sensitive to higher rates and inflation, according to

Truist's Lerner.

The Russell 2000 held a 37% weight with those two sectors as

of the end of 2024, compared to a roughly 22% for those groups

in the large-cap S&P 500.

Trump's arrival presents an opportunity for small caps,

BMO's Ma said, "but that thesis for outperforming probably

hinges more on a favorable interest rate environment."