With the current consensus that the Fed will be more hawkish regarding rates, a familiar narrative has returned: rising interest rates are bad for small-cap stocks. The logic is straightforward: smaller companies are perceived as being more leveraged, more dependent on external financing, and therefore more vulnerable to higher borrowing costs. As a result, the argument goes, when the Federal Reserve tightens monetary policy, small caps are destined to underperform.

It's an intuitive argument. It’s just one that history does not support.

As we looked across previous Federal Reserve tightening cycles, we found little evidence that higher interest rates consistently translated into weaker small-cap performance. In fact, excluding the most recent tightening cycle—which was heavily influenced by the extraordinary concentration of returns among the ‘Magnificent Seven’—small-caps have, on average, outperformed large-caps during periods of rising rates. Including the most recent, ‘Magnificent Seven’ dominated cycle, leadership becomes more balanced, but the broader conclusion remains unchanged: rising rates alone have not been a reliable predictor of relative returns between small- and large-caps.

The same pattern emerges during easing cycles. Lower interest rates have generally been supportive for equities but have not consistently favored either small- or large-cap stocks. Leadership has shifted from one cycle to the next, suggesting that monetary policy itself has rarely determined market leadership.

If the historical relationship between interest rates and small-cap performance is so weak, why does the perception persist? Part of the answer lies in another widely held assumption—that small-cap companies are broadly overleveraged. In reality, the Russell 2000 is far more financially diverse than many investors appreciate.

According to Furey Research Partners, approximately one-third of the companies in the index hold more cash than debt, while nearly half of the index’s total debt is concentrated in companies representing just 12% of its market capitalization. Many small-cap businesses also do not rely on debt as a primary source of capital, instead funding growth through internally generated cash flow, disciplined capital allocation, or equity financing. In other words, investors often speak about the Russell 2000 as though it represents a single balance sheet. It doesn't. It represents nearly 2,000 companies with dramatically different capital structures, financial profiles, and competitive positions. Taken together, the historical performance data and financial characteristics of today’s small-cap universe challenge one of the market’s most enduring myths.

So, if interest rates have not consistently explained small-cap performance (and many companies are far less dependent on debt than commonly believed) what does drive small-cap returns?

The answer is remarkably simple: Earnings.

For the purposes of this argument, we looked at data for the S&P SmallCap 600 Index because it requires that companies be profitable for inclusion (among other criteria) and rebalances less frequently than the Russell 2000. The data in the chart below shows that, over the long term the S&P 600’s price performance closely tracked the growth in corporate earnings, illustrating that fundamentals—not interest rates—have been the dominant driver of returns.

Earnings Primarily Drive Small-Cap Returns
S&P SmallCap 600 Earnings Growth vs. Price Growth, 7/31/01-7/31/25

Source: FactSet. Past performance is no guarantee of future results.

Over the past two decades, stock prices have periodically moved ahead of, or fallen behind, corporate earnings as investor sentiment shifted. Yet over time, prices and earnings have consistently converged. Interest rates can influence valuations and investor sentiment over shorter periods, but long-term returns have ultimately followed the direction of earnings.

This also explains why the relationship between interest rates and small-cap performance has often appeared inconsistent. The Federal Reserve typically raises rates because economic growth is strengthening and corporate earnings are improving. Conversely, it generally lowers rates when growth is slowing, and earnings expectations are deteriorating. In both cases, the earnings outlook, as opposed to the direction of interest rates, has historically been the more important driver of returns.

For investors, we think the implication is straightforward. Rather than asking whether interest rates are moving higher or lower, we think the better, more relevant question is whether corporate earnings are likely to accelerate or decelerate. The temptation during every market cycle is to reduce investing to a single macro variable. Today, that variable is looking more and more like it will be interest rates. History suggests, however, that it may be better to focus on the factors that have consistently driven long-term returns: Earnings growth, balance sheet strength, and business quality. That is particularly true in small-caps, where the opportunity set is exceptionally diverse. Companies differ dramatically in their financial strength, competitive advantages, earnings trajectories, and management teams. Those differences matter far more than broad assumptions about the direction of interest rates.

When investors become fixated on macro narratives, they often overlook the significant differences among individual businesses. That is precisely where active management can add value. By focusing on fundamentals rather than headlines, active managers can identify financially strong companies with growing earnings, sound balance sheets, and durable competitive advantages whose intrinsic value is not yet fully reflected in their share prices. History suggests those distinctions—not the direction of interest rates—have been the more reliable driver of long-term small-cap returns.

Stay tuned…

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