RUSSELL 2000 OUTLOOK:
- A cyclical small-cap relief could materialize once the economic recovery stabilizes
- A rotation into small-cap could lift the Russell 2000 higher over the medium term
- The bullish Russell 2000 thesis could be played via the IWM ETF
Most read: Financials and Energy Stocks May Have Upside Potential, XLF and XLE Look Attractive[1]
Inflation can be positive for small-cap and cyclical companies when it is accompanied with strong economic growth. On the flip side, when inflation runs hot, it is supply driven and economic activity starts to disappoint, small-caps don’t tend to perform well as mounting price pressures eat into profit margins rapidly.
In early summer, as U.S. CPI touched its highest levels in a generation and delta-variant fears caused output to start downshifting, the specter of “stagflation” spooked investors, prompting traders to cut exposure to cyclical stocks. This fear, whether justified or not, was probably responsible for the Russell 2000's poor performance over the past few months (the Russell 2000 is a cyclically oriented small-cap index).
The good news now is that inflation appears to be easing[2] after supercharged readings earlier in the year. This dynamic may alleviate pressure on margins and create a friendlier setting for small caps with little pricing-power.
Related: S&P 500, Dow Jones, DAX 30 Look Increasingly Vulnerable as Long Bets Accumulate[3]
With inflationary pressures losing some impetus, there could soon be a rotation into cyclicals and small-caps again, a scenario that stands to benefit the Russell 2000. The bullish thesis, however, is based on the conjecture that the recovery will stabilize and the labor market will improve in the coming months.
Investors and consumers have become overly gloomy about the economy on account of the latest COVID-19 wave driven by the delta-variant,
