Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Russell 2000 Is Lagging the S&P 500
Transcript
- Lucas: The S&P 500 is sitting at 7,483, up nearly 2% over the past five trading days. The Dow and Nasdaq are also up about 2%. But the Russell 2000, the small-cap index, actually fell half a percent in that same window. Luna: That's a pretty big divergence. Is this just the mega-cap tech effect again? Lucas: Partly, yes. But I think there's something deeper going on. The Russell has been underperforming the S&P for most of 2026. And if you look at the yield curve, you see part of the reason. The 10-year Treasury yield is now at 4.49%, up about 2.6% in just the last week. The 2-year is at 4.23%. Luna: So the spread between the 10-year and the 2-year is about 26 basis points. That's a pretty normal positively sloped curve. Lucas: Right. The curve is no longer inverted — it normalized earlier this year. But the level of rates matters more for small caps. These companies typically have higher debt loads and shorter-duration debt, so they're more sensitive to rising yields. A 4.49% 10-year means their refinancing costs are significantly higher than they were a couple of years ago. Luna: And larger companies, especially the mega caps, can lock in longer-term debt at lower spreads, or they generate enough cash to not need as much borrowing. Lucas: Exactly. Apple and Microsoft are sitting on huge cash piles. A small regional bank or a niche manufacturer doesn't have that luxury. So when rates stay elevated, it squeezes their margins and their growth prospects. Luna: The other piece is the labor market. We just got the June jobs report — only 57,000 new payrolls. That's pretty weak. Yet the unemployment rate dropped to 4.2% from 4.3%. Lucas: That drop happened because the labor force participation rate fell. Fewer people are looking for work, so the share of people employed versus those looking actually improved. But the headline number — 57,000 jobs — is the softest we've seen in months. Luna: Small caps tend to be more exposed to the domestic economy, so a soft jobs report hits them harder. The mega caps, especially the tech ones, have more global revenue streams. Lucas: That's a great point. If the U.S. economy is slowing, companies that rely on American consumers and businesses feel it first. The Russell 2000 is mostly domestic. The S&P 500 includes companies like Apple, Microsoft, and NVIDIA that sell all over the world. Luna: And it's not just revenue exposure. The Russell is heavily weighted toward financials, industrials, and consumer cyclicals. Those sectors are rate-sensitive and growth-sensitive. Lucas: Let's look at financials specifically. Regional banks are a big part of the Russell. They borrow short-term and lend long-term, so a steep yield curve is actually good for them — they can borrow at 4.23% on the 2-year and lend at 4.49% on the 10-year. But the absolute level of rates means loan demand is weaker, and they have to pay more for deposits. Luna: So the curve shape helps, but the level and the economic backdrop hurt. That's a mixed signal. Lucas: Exactly. And the Fed is stuck at 3.63% on the fed funds rate. They haven't moved since early this year. The market is pricing in maybe one cut by December, but it's not certain. So small caps are in this waiting room — higher rates, slowing growth, and no clarity on when relief comes. Luna: It's interesting that the 10-year breakeven inflation rate is only 2.23%. So the bond market doesn't expect inflation to be a problem. That should be good for small caps — lower inflation means lower input costs. Lucas: But the problem is that inflation isn't falling fast enough to get the Fed to cut. Core CPI is at 336.1, up from 335.4 last month. Core PCE is also creeping higher. So the Fed is stuck between sticky inflation and a softening labor market. Luna: That's the worst of both worlds for small caps. Not bad enough for the Fed to rescue them, but not good enough for them to thrive on their own. Lucas: A couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Luna: Yeah, it makes a real difference. Keeps the show ad-free and independent. Lucas: Absolutely. So back to small caps — what would change the narrative? If the Fed actually cuts rates, or if we see a pickup in domestic demand, the Russell could catch up quickly because valuations are relatively cheap. Luna: But you need a catalyst. Right now, the market is rewarding size and global diversification. The Russell is trading at about 15 times forward earnings, while the S&P is at 22. That discount is usually a buy signal, but only if earnings improve. Lucas: And earnings for small caps have been under pressure. Analysts are projecting a decline in profits for the second quarter. Meanwhile, the mega caps keep beating estimates. Luna: So the market is rational in that sense. It's not just about size — it's about earnings power. Lucas: Right. And that's the key takeaway for today. The Russell's underperformance isn't a mystery. It's a reflection of higher rates, a softening domestic economy, and a Fed that can't cut yet. The S&P 500's rally is being driven by a handful of stocks that can navigate this environment. Breadth is narrow. Luna: So for investors, the question is: do you wait for the rotation, or do you follow the momentum? Lucas: And that's the debate we'll keep tracking. The data next week — jobless claims, CPI, retail sales — could give us more clues. But for now, the message from the market is clear: size matters.