The recent rally in small-cap stocks can be attributed to several key factors, many of which align with the broader macroeconomic and market trends we’ve been observing over the past few months. Here are some possible reasons for the recent small-cap rally:

1.Economic Recovery/Expansion:

• Growth Potential: Small-cap stocks typically represent younger, smaller companies with greater growth potential. When the economy is expanding or recovering, these companies tend to outperform their larger counterparts due to their ability to scale faster.
• Increased Demand: As the economy grows, demand for goods and services may increase, benefiting small-cap companies that are more nimble and adaptable compared to larger firms.

  2. Interest Rate Environment

Falling Interest Rates: The recent trend of interest rates of decreasing have helped small-cap stocks. Lower interest rates make it cheaper for small companies to borrow money to expand. Additionally, small companies are generally more sensitive to interest rate changes, and a stable or low rate environment benefits their growth prospects.

Growth-Dependent Stocks: Small-cap stocks are often considered “growth” stocks, and lower interest rates are conducive to growth stocks outperforming, especially in a scenario where inflationary pressures seem to be cooling.

3.Diverging from Larger Cap Stocks

• Underperformance in 2022-2023: Small-cap stocks lagged large-cap stocks for much of 2022 and early 2023. After underperforming, they can become attractive as undervalued assets. As large-cap stocks have cooled off a bit, there’s been a rotation toward smaller companies seen as having more room for growth.
• Catching Up to Larger Growth: Small caps have often lagged behind larger companies in past bull markets, so investors may be taking advantage of that “catch-up” phase.

4.Inflation and Commodity Prices

Inflation Hedge: Some small-cap stocks, particularly in the commodities and materials sectors, benefit from inflationary pressures as their products or services become more valuable during inflationary periods. These sectors have seen strong rallies as inflation has remained a concern.

Rising Commodities: Small-cap stocks in the energy, metals, and agriculture sectors could be benefiting from rising commodity prices, which tend to help companies in these industries.

5.Technical Factors

Momentum and Technical Breakouts: Sometimes, small-cap stocks rally simply because they are in a technical breakout phase. Strong momentum can attract more investors, pushing prices higher. Traders may be jumping in on short-term price patterns or the fear of missing out (FOMO) on the rally.

6.Geopolitical Stability

Relief from Geopolitical Risks: In periods when geopolitical risks settle down, there’s a renewed appetite for riskier assets, including small-cap stocks, which may have been under pressure earlier.

In short, the rally in small-cap stocks is likely being driven by a combination of positive economic data, shifting investor sentiment, sector-specific booms, and an environment of low interest rates. Investors are looking to capitalize on growth opportunities in smaller companies, especially those in emerging industries, with the expectation that they will outperform as the economy continues its recovery.

Lauren Hua is a private client adviser at Fairmont Equities.

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