Are higher rates catching up with small caps?

Through the first half of 2026, U.S. small‑cap stocks had an exceptional run. But since the end of June, that momentum has reversed.

From June 30, 2025, through June 30, 2026, the S&P SmallCap 600 Index (S&P 600) returned roughly 38%, while the Russell 2000 gained more than 40%. Since then, both indexes have fallen around 6% to 8% through October 27, 2026.

So what changed?

The answer appears to be a combination of persistently high interest rates and signs that small‑cap earnings growth may be approaching a peak.

Small‑caps are especially vulnerable to higher interest rates for two reasons. First, smaller companies carry considerably more leverage than their large‑cap counterparts. Second, the small‑cap universe has greater exposure to rate‑sensitive areas of the economy, including housing, financials, and other traditional cyclical industries.

The gap with large‑caps has widened

The balance‑sheet vulnerability has increased substantially over time. In 2010, total debt represented roughly 25% of assets for the S&P 600, compared with about 28% for the S&P 500. Today, small‑cap leverage has risen to approximately 39%, while large‑cap leverage remains close to where it was 16 years ago.

That higher debt burden has made financing costs increasingly important. Interest coverage for the S&P 600 has deteriorated to a little over four times interest expense. For the S&P 500, coverage is nearly 13 times. That leaves smaller companies with considerably less room to absorb persistently high borrowing costs as existing debt gradually reprices.

Valuations have moved inversely to yields

The market has historically reflected this balance‑sheet sensitivity through lower valuations when interest rates rise. Since 2014, the correlation between the 10‑year Treasury yield and the S&P 600’s forward price‑to‑earnings ratio has been approximately –0.6. Put simply, higher yields have generally been associated with lower small‑cap valuation multiples.

That relationship makes sense. When financing costs rise, investors demand a lower price for companies that carry more debt and have less capacity to absorb the added expense.

So the valuation pressure we are seeing today is not a separate issue. It is one of the ways higher rates and greater leverage are being reflected in small‑cap prices.

Earnings did the heavy lifting

For much of 2025 and the first half of 2026, small‑caps were able to overcome that pressure because earnings were improving rapidly.

Earnings estimates had been climbing steadily since mid‑2023, and actual earnings delivery also improved. In recent months, small‑cap companies have even been beating the expectations that analysts had set a year earlier. That fundamental strength helped offset the drag from higher interest rates and supported strong equity returns.

The concern now is that this earnings tailwind may be beginning to fade. Forward 12‑month earnings growth expectations for the S&P 600 reached roughly 19% in early July but have since declined to about 17%.

The risk: Pressure from both sides

Actual earnings remain healthy, but the question is whether that can continue if higher rates increasingly slow activity in the parts of the economy where small‑caps are most exposed.

If earnings growth continues to moderate while rates remain elevated, small‑caps could face pressure from both sides: Weaker earnings growth and lower valuation multiples.

Conclusion

We are not yet convinced that this more difficult scenario will fully materialize. Small‑cap earnings remain healthy, and valuations have already adjusted considerably from their midyear highs.

However, the backdrop has become less favorable. Small‑caps are carrying significantly more leverage than they have historically. Meanwhile, interest coverage has deteriorated, and the earnings acceleration that previously offset higher rates appears to be moderating.

If rates continue to move higher, those pressures could become increasingly difficult to overcome. Reflecting that changing balance, our Asset Allocation Committee has recently begun trimming its exposure to U.S. small‑cap stocks.