KEY POINTS:
- Rate cuts and benign economic conditions have stimulated a long-awaited earnings recovery for US small-cap stocks
- A persistent valuation discount to large caps, combined with improving fundamentals, creates a compelling entry point for investors willing to look beyond the dominant large-cap narrative
- Concerns about the valuations of mega-cap technology stocks are driving interest in other, less fashionable parts of the US market
- Small-caps’ domestic revenue focus provides a degree of insulation from trade policy and disruption
- Selectivity is essential: the breadth and diversity of the small-cap universe requires fundamental analysis to identify the best opportunities
After years of lagging their large-cap counterparts, US small-caps are experiencing a recovery. And this time, the fundamentals supporting the renaissance are tangible with earnings rebounding. Smaller companies are well positioned to take advantage of a resilient American economy, less restrictive monetary policy and an inflection in cyclical activity. The US labour market remains stable,1 and heavy investment in AI infrastructure is generating demand that reaches well beyond the mega-cap technology companies that had dominated equity returns in prior years.
This earnings inflection is the primary reason small-cap outperformance has been sustained for a longer period. The Russell 2000 Index outperformed the S&P 500 for much of 2025,2 and the tailwinds driving that performance remain in place heading into 2026.
A turning point for smaller companies
The high levels of inflation and rising interest rates seen from 2022 onwards created particularly challenging conditions for global small-cap companies, which are typically more sensitive to financing costs than their larger, better-capitalised counterparts. In the US, the sector was further impacted in early 2025 by uncertainty around trade policy – most acutely in the lead-up to President Trump’s ‘Liberation Day’ tariff announcement in April.
Since then, however, conditions have improved markedly. The tariff-driven disruption many investors feared was far more benign than expected, and the Fed resumed its programme of rate cuts in September, with two further reductions before the end of the year. This created significantly more favourable conditions for companies looking to raise capital or refinance existing debt.
At the same time, small-cap stocks’ greater focus and reliance on the domestic market gives them a degree of protection against the vagaries of the Trump administration’s international trade policy. This domestic focus also positions them as natural beneficiaries of reshoring and onshoring trends, as companies reconfigure supply chains to reduce dependence on foreign manufacturing.
Closing the valuation gap?
The divergence in performance in recent years between large- and small-cap shares has created a significant valuation differential. Small cap valuations are reasonably priced by historic standards but are trading at a steep discount to large-cap stocks. Valuation discounts are not a powerful indicator for future near-term performance, but when accompanied by market catalysts upside catalysts are amplified.
The mechanism that could close this gap is the earnings recovery now underway. As rate cuts feed through into lower financing costs and improved profitability for smaller companies, the fundamental case improves and the opportunity for a concurrent rerating also strengthens.
Meanwhile, interest in smaller companies is broadening as investors question the concentration of returns from the AI theme in a narrow group of mega-cap tech stocks. Smaller companies are playing an increasingly important role in AI-related supply chains alongside the major hardware manufacturers, in areas such as data-centre construction and component manufacture. Essentially, many smaller companies are providing the ‘picks and shovels’ for the AI gold rush, meaning the small-cap market is benefiting from something of a trickle-down effect.
At the same time, smaller firms are deploying AI internally, improving productivity and margins. And new legislation in the form of the One Big Beautiful Bill Act of 2025 provides significant incentives for firms of all sizes to make capital expenditures. Combined with lower financing costs, this could boost growth throughout the whole of the US economy in 2026 and beyond.
Navigating the risks
The positive outlook is not without caveats. For one, the AI picture has proven muddier than investors initially thought. This was evidenced by sharp software sector sell-offs in early 2026 – the result of investors reassessing which business models are vulnerable to AI disruption on the back of new evidence from recently released frontier models.
Conflict in the Middle East has sent oil prices skyrocketing and raised investor concerns of a resurgence in inflationary pressures. Any expectation of further rate cuts this year remains on hold for as long as these conditions persist. But a timely resolution could rapidly reverse this trend and forward-looking market participants may not wait for an all-clear signal.
Elsewhere, the industrials sector has surged year-to-date, driven by sharp rallies in electrical, construction and engineering equipment. Biotech, after suffering under the higher-for-longer rate regime, has begun a recovery as monetary policy becomes more accommodative, though the path is unlikely to be linear.
Identifying growth opportunities
Perhaps the most significant challenge facing investors in the US small-cap sector is the sheer breadth and diversity of the universe. Even during periods when broader trends and macroeconomic conditions are supportive of the market in general, identifying the individual companies best placed to take advantage of these conditions is far from straightforward.
Understandably, smaller companies receive much less coverage from sell-side analysts and the media than for large-cap businesses, creating both information asymmetry and potential mispricing. Therefore, the most effective approach is likely to be one that is highly selective. Deep, bottom-up research is essential to identify the best opportunities.
The recent volatility in the software sector illustrates this clearly. For experienced stock-pickers, the type of indiscriminate sell-off we saw in the early weeks of 2026 can generate highly attractive opportunities. In such an environment, the key to success is the ability to work out which business models are truly vulnerable, and which companies have the capacity to leverage AI integration to create a new competitive advantage.
We believe active risk management is also crucial. Investment managers need to take into account factors such as overall portfolio diversification and avoid excessive sector concentration, as well as potential liquidity issues. The trading of small-cap stocks can be much less liquid than shares in larger companies.
Our investment approach
At BNP Paribas Asset Management, our goal is to unearth stocks in the US small-cap universe that have the potential to deliver strong long-term growth at the right price. Our highly experienced investment team is packed with specialists, many of whom are involved in the management of separate sector-specific funds in the US and other markets. These include disruptive technology, health care innovation and consumer innovation.
We seek investments that fit with our views on the most impactful themes and industries that we expect to drive earnings growth over the medium to long term. Given the tailwinds currently supporting gains among small-cap stocks, we are confident that our approach can continue to create attractive investment opportunities for our clients.
Find out more about BNP Paribas Asset Management’s US Small Cap strategy here.
Source: BNP Paribas Asset Management, March 2026
[1] US weekly jobless claims fall more than expected amid labor market stability | Reuters
[2] https://curvo.eu/backtest/en/compare-indexes/russell-2000-vs-sp-500?currency=usd
At the time of writing 31/3/2026, the Middle East conflict has not warranted any major changes to our base case macroeconomic outlook or investment recommendations. To follow our analysis of the events driving asset markets, go to Viewpoint at https://viewpoint.bnpparibas-am.com.
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