A Wobble in the Russell 2000 Small Caps Rotation

Small caps experienced a surge in November, propelled by the 'Trump effect' and a broader rotation towards the Russell 2000 since the summer months. Still, the pertinent question is whether the momentum will sustain itself through the winter season.

The Great Rotation Continues

The Russell 2000 index has experienced notable gains in November, rising over 4.5% in the first two weeks of trading attributed to the so-called ‘Trump effect’ since the election. While some of these gains have been retraced in recent sessions, the index remains on an upward trajectory, having grown 15% year-to-date.

This strength in small-cap stocks has been attributed to a broader rotation from mega-caps into more agile firms with potentially better growth prospects in a low-interest-rate environment, as analysts observed earlier in the summer.

However, since the election of President Trump, bond yields have been trending higher as investors anticipate that tariffs and economic growth may contribute to higher inflation. This, in turn, could limit the scope for further interest rate cuts by the Federal Reserve, calling into question the sustainability of the outperformance of the Russell 2000 index.

Typically, lower interest rates benefit smaller stocks, while higher rates make it more challenging for these companies to access growth capital.

An Ambiguous Situation

Small caps face a delicate balance under a Trump presidency. On the one hand there is the negative prospect of higher inflation eroding profit margins and keeping interest rates higher, while on the other there are  potential benefits from lower taxes, reduced regulatory burden, and protectionist tariffs.

These factors cannot all occur simultaneously or have equal effects. President-elect Trump will not assume office for another two months; after that, it will take months or even years to see the impact of his policies. Tariffs can be implemented sooner than tax cuts, for example. The inflationary effect of tariffs - and depending on their implementation, could be minimal or non-existent - and might only be felt in the second half of 2025 or later.

In the interim, the Federal Reserve will respond to evolving data. Inflation is expected to remain subdued for several more months, implying that the Fed will continue easing monetary policy. Rate cuts may not come at the same pace as was expected before the start of November, as Fed Chair Jerome Powell asserted in a speech yesterday, but easing will likely support small-caps in the short term.

While the post-election surge might have led to profit-taking and investors have become more cautious as they await Trump's actual policies, there are reasons to expect the Russell 2000 can at least maintain its pre-election upward trend, barring any unexpected events.​

Russell 2000 in Pullback Mode

The Russell 2000 met stiff resistance at the 2450 peak formed in 2022, which could be the beginning of a double-top. Crucial support below 2300 sits at the 2190 swing, followed by the 2080 and the 2000 handle. Conversely, if prices edge past the recently formed peak, the measured move projection of the 2300-2000 downside leg points to a potential move towards 2635.​

Source: SpreadEx / US Russell 2000

Key Takeaways

Small-caps in the Russell 2000 index experienced a surge in November driven by the 'Trump effect' and a broader rotation from mega-cap companies. However, the sustainability of this momentum remains to be determined.

While lower interest rates typically benefit smaller stocks, the prospect of higher inflation and gradual easing could limit further gains. The impact of Trump's policies on factors like taxes, regulations, and tariffs needs to be clarified, and their effects may take time to materialise.