From the Market Desk: The Rise of the Small Caps

by Chris Galipeau of Franklin Templeton, 9/24/25

Macro

  • The federal funds (FF) futures market is pricing in two more interest-rate cuts in 2025. As of today, the market indicates a 91% chance of a 25-basis-point (bp) cut in October and an 86% chance of a 25-bp cut in December. The projected terminal FF rate for 2025 is 3.63%.
  • US two-year Treasury note yields suggest the probability of two more rate cuts in 2025. These two-year yields are about 50 bps below the FF rate, and historically the Federal Reserve (Fed) has moved rates in the direction of two-year yields.
  • In the coming week, we will get the Personal Consumption Expenditure (PCE) report for August. The market consensus expectation is a 2.9% year-over-year (y/y) increase, which would be in line with the July report.
  • Also, regarding inflation, breakeven rates are now clustered together. The one-year breakeven inflation rate is 2.71%, the two-year rate is 2.59% and the five-year rate is 2.48%.

Equities

  • As I wrote about last week, when the Fed resumes an interest-rate cutting cycle after a pause, equity returns have historically been positive one year out from the first post-pause cut, based on the cycles we identified going back to 1974. Specifically, the S&P 500 Index returned an average of 17% in the eight periods in which the Fed has cut rates after a pause.1
  • During these post-pause cutting cycles, the Nasdaq Composite has led the major US indexes by posting one-year returns averaging 25%.2 The Russell 2000 Index posted the second highest return of 20% on average over the post-pause one-year periods.3 Keeping in mind that every period is different, and history is not a guarantee of the future, we found many equity and fixed income asset classes had positive returns in post-pause rate-cutting cycles. You can read the details in our white paper, “How US equities and US fixed income performed with a resumption of Fed easing.”
  • We are now expanding this research to non-US assets, and one early observation is that on a global basis, emerging market (EM) equities have been the top performer one year after the Fed cuts rates after a pause. The EM average return was 27% (based on the performance of the MSCI Emerging Markets Index) in rate-cutting cycles in the years 1990, 1995, 2002, 2003, 2008 and 2020.4
  • I speak with financial advisors on a regular basis, and recently I have heard two themes from quite consistently: First, a majority express hesitance to own EM or developed market (DM) international equities. Second, they are even more reluctant to own small-cap US equities. Most of that reluctance stems from the underperformance of these three areas for the past 15 years. Their concern is "statement risk,” meaning that they could get a call from clients who see an underperforming non-US investment on their statement. I understand this concern.
  • However, for 2025 and 2026, we believe some of the strongest cumulative earnings growth is likely to be found in these areas: US small caps, EMs and DMs, and particularly in places Europe and India. So, the setup is interesting—in our view, these asset classes are likely to have the strongest earnings power, and we also observe they have the most negative sentiment for now.
  • We are bullish on small-cap stocks, considering the combination of their likely earnings power as well as our research data that shows small-cap stocks have performed well after the Fed resumes interest rate cuts after a pause.
  • Let’s not overlook that small-cap stocks hit a new all-time closing high on Thursday, September 18, as measured by the Russell 2000 Index. This may be a bit under the radar—that small caps have rallied. Measured from the stock market’s intraday lows last April, the best-performing US index has been the Nasdaq Composite, up 52%, while the Russell 2000 was second, with a gain of 43%.
  • When the Fed cuts rates after a pause, history tells us that we should expect volatility to creep up in the first few months. We consider it prudent to be alert for market weakness, but given the historical data, this volatility may also offer attractive opportunities to invest in different areas of US and international markets.
  • Regarding where the broad US market is likely to trend in the final three months of 2025, we point to our Global Investment Management Survey of investment professionals across Franklin Templeton, which has an S&P 500 year-end target range of 6400 to 6800.