Key insights
- The IWM ETF has seen significant gains driven by easing tariffs and anticipation of Fed rate cuts. However, the resurgence of the AI trade and persistent inflation, geopolitical uncertainty, and higher-for-longer interest rates present headwinds. The future performance of small caps hinges on whether economic growth and earnings can overcome these challenges, making the current outlook for US equities mixed.
After a strong start to 2026, the iShares Russell 2000 ETF (IWM 0.55%) is up 18% year to date. That nearly doubles the 10.7% return for the S&P 500. But the early momentum for small caps and other non-tech stocks has faded once the artificial intelligence (AI) trade returned in full force in April.
Now investors need to weigh a positive outlook for economic growth and corporate earnings, but also deal with higher inflation, an uncertain geopolitical environment, and higher-for-longer interest rates. Which of these factors wins out will likely determine whether small caps are still a buy here.
Toward the end of 2025, small caps were being weighed down by the pressure of high interest rates and the financial impact of tariffs. Small companies tend to be more debt-dependent than large ones, so higher rates present a greater relative financial cost. Tariffs also disproportionately hurt small caps because they don't have the ability or flexibility to easily alter supply chains or negotiate terms as large companies do.
In February 2026, however, the Supreme Court struck down many of the U.S. tariffs issued in 2025 as unlawful. With that major headwind eased, small caps now had a more optimistic outlook.
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Early in the year, markets also anticipated that the Federal Reserve would be able to cut rates later in 2026. Rate cuts often provide a boost to small caps because, again, they can reduce debt servicing costs and improve financial health.
Those two factors were a major reason small caps rallied in the first quarter.
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Today, it looks increasingly unlikely that the Fed will be able to cut rates. The annualized inflation rate is approaching 4% again following the months-long conflict in the Middle East, and the Fed may actually need to consider hiking before cutting.
But the biggest catalyst for small caps in the remainder of 2026 will be earnings growth.
A big reason why small caps have struggled is that earnings growth has largely stagnated. That trend is beginning to reverse. In 2026, Russell 2000 components are expected to deliver 19% year-over-year earnings growth, significantly higher than the 13% growth rate currently forecast for stocks in the S&P 500.
Even after this year's rally, the iShares Russell 2000 ETF still only trades at a forward price/earnings (P/E) multiple of 17, a better value than the 20 times earnings the S&P 500 currently trades at.
Whenever you're looking at a group of stocks with a forecast 19% earnings growth but a forward P/E ratio of just 17, that's a strong risk/reward profile.
The interest rate and inflation outlooks complicate things, but the iShares Russell 2000 ETF still looks like a buy. Over the long term, earnings growth tends to drive stock prices. For the first time in a few years, small caps are about to get that tailwind.