Chart of the Week

Sizing up small caps

July 21, 2026

Time to Read: 3 mins

Small caps have outperformed this year despite the threat of higher interest rates, suggesting the rally is being driven by more than just diversification away from large cap tech stocks. Improving earnings expectations and a resilient U.S. economy support our view that small caps have further upside from here.

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Despite the risk that war-driven energy inflation could keep interest rates higher for longer — or cause the Federal Reserve to tighten monetary policy — small cap stocks have been among the best-performing asset classes year to date. That is especially notable because small caps are typically one of the most interest-rate-sensitive areas of the market.

While some investors are using small caps to diversify beyond crowded large cap tech leadership, the fundamentals also appear to justify the rally. After a period of negative earnings growth in 2023 and 2024, small cap earnings growth recovered to 14% in 2025 and is expected to accelerate to 20% this year and 18% next year. That trajectory demonstrates a meaningful rebound in profit growth and supports the case for higher valuations. Small caps also continue to benefit from a resilient U.S. economy because of their more domestic orientation.

We therefore believe small caps have further upside from current levels. While rate volatility remains a risk, improving earnings and a broadening market backdrop should continue to support the group. As a result, we advise clients to consider adding exposure to small cap companies within a globally diversified equity allocation.

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In a real regime shift?

Higher inflation has been a dominant theme of the current decade. In addition to price shocks, it is being shaped by secular investment trends in infrastructure, defense spending, onshoring and the ongoing AI buildout. These structural changes reinforce the case for looking beyond traditional 60/40 portfolios to include real assets as a source of diversification and return potential in portfolios.

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Getting real with real assets

Inflation appears to have transitioned from its pre-Covid average of 2% to a stickier point closer to 3%, and we do not expect a near-term return to prior levels. In this environment, we believe real assets, such as commodities, infrastructure and REITs, can provide inflation protection, diversification and return potential.

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Not in a bubble

As the S&P 500 approaches all-time highs, there are renewed concerns among investors about elevated valuations. However, historically strong profitability and expected earnings growth appear to support current pricing. In addition, the current S&P 500 price-to-earnings (P/E) ratio is roughly equal to the average since Covid. As a result, we do not view U.S. equities as being in bubble territory and we remain constructive on the asset class.

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Is the market rally broadening?

Stocks, as measured by the S&P 500, are up over 13% through early August. The solid gains have been fueled by a resilient economy, steady consumer spending, optimism around artificial intelligence and better-than-expected earnings growth. Still, some investors worry the advance may be too concentrated in technology and that AI-capex monetization may fall short of expectations. A closer look suggests that it is not just tech moving the market higher.