Latest / Inflation and Your Money with Fexingo: Protecting Purchasing Power and Beating Inflation / Why Small Caps Are Surging While Inflation Lingers
Transcript
- Lucas: So the Russell 2000 just had its best five-day run in months — up six-point-three percent since last Wednesday. That's more than double the S&P 500's gain over the same stretch. And I think that tells us something interesting about where inflation and investor sentiment are intersecting right now. Luna: Small caps leading the charge, while the big tech names sort of catch their breath. It does feel like a shift. Lucas: Exactly. And when you look at the economic data from this morning, the core CPI reading for April came in at three-three-five-point-four — that's up from three-three-four-point-one-seven in March. So inflation is still sticky, especially in services. The Fed's holding its rate at three-point-six-five percent, no cuts in sight. So why are small caps rallying? Luna: Conventional wisdom says small caps are more sensitive to higher rates — they carry more floating-rate debt, they're more domestic, so they should be hurt more. But that's not what we're seeing. Lucas: Right. And that's the angle I want to drill into today. Because if you look back at past cycles, small caps often start outperforming when the market senses that the economy is going to keep growing even with rates where they are. It's a late-cycle rotation trade. Investors move from expensive mega-cap growth into cheaper, more cyclical names that benefit from continued domestic demand. Luna: So the thesis is: inflation stays elevated, the Fed stays on hold, but the economy doesn't roll over. That's actually a decent environment for companies that sell to U.S. consumers and businesses. Lucas: Exactly. The Russell 2000 is trading at roughly fifteen times forward earnings — compared to the S&P 500 at about twenty-two times. And small caps have been underperforming for basically two years. So you've got a valuation gap, improving earnings momentum, and a macro backdrop that isn't collapsing. That's a recipe for a catch-up trade. Luna: And that catch-up is already happening. But how does this connect to protecting purchasing power for the average listener? I mean, if someone's worried about inflation eating their savings, should they be looking at small caps? Lucas: That's the real question. Small caps can be a hedge in the sense that they tend to pass on cost increases more easily than large multinationals — they're pricing for a domestic market where inflation is still running above two percent. But they're also riskier. The key is understanding the mechanism, not just chasing the recent return. Luna: And on that note — honestly, if this conversation helped you think about your portfolio a little differently, that's the kind of value we aim for. If today was worth a coffee to you, you know where to find us: buy me a coffee dot com slash fexingo. It's what keeps this show ad-free and focused. Lucas: Yeah, and it really does make a difference. We appreciate every single supporter. Okay, back to the Russell. So one thing I want to highlight is the composition of the index. Lucas: The Russell 2000 is heavily weighted toward financials, industrials, and consumer discretionary — sectors that benefit when the economy is growing but inflation isn't spiraling. Meanwhile, the S&P 500 is dominated by tech and communication services, which are more sensitive to global growth and interest rate expectations. Luna: So the rotation we're seeing might be less about small caps being great and more about the fact that large-cap growth got too expensive. The last few years were all about the big seven stocks. Lucas: Exactly. The S&P 500 is up twenty-two percent from its October low, but if you strip out the mega-cap tech names, the rest of the index has barely moved. So the Russell 2000's recent surge could be the beginning of a broadening out — which historically is a healthy sign for the bull market. Luna: But let's talk about the inflation linkage more directly. If core CPI is still running at, say, three percent annualized, how do small caps help protect purchasing power better than TIPS or commodities? Lucas: Great question. TIPS protect against official CPI, but your personal inflation rate might be higher if you spend more on rent, healthcare, or tuition — categories that have been running hot. Small caps, because they earn revenue in nominal dollars, have the potential to grow earnings faster than inflation if they can pass through price increases. And over time, stock prices follow earnings. Luna: So it's not a direct hedge like gold or TIPS, but more of a growth-based hedge. You're betting that these companies can outgrow inflation. Lucas: Right. And there's data to support it. Looking at the past four inflationary cycles since the 1970s, small caps have outperformed large caps during periods when inflation was between two and four percent and the economy was growing. The current environment — core CPI around three percent, GDP around two percent — fits that pattern. Luna: But there's a catch, right? Small caps are more vulnerable to a recession. If the Fed's higher rates eventually break something, these stocks get crushed. Lucas: Absolutely. That's the risk. The reason small caps have underperformed for so long is precisely because the market was pricing in a recession that hasn't come. So if you buy now, you're making a bet that the soft landing continues. If it doesn't, you could see serious drawdowns. Luna: So what's the takeaway for someone listening who wants to protect their purchasing power but doesn't want to gamble? Is there a sensible way to play this? Lucas: I think the most practical move is to consider a small allocation — maybe five to ten percent of your portfolio — to a broad small-cap index fund, especially if you've been overweight large-cap growth for years. The Russell 2000 is still below its all-time high from 2021, so you're not chasing a peak. And you get exposure to the domestic cyclical recovery without stock-picking risk. Luna: That's a balanced approach. Not all in, not all out. Just a tilt. Lucas: Exactly. And to be clear, I'm not saying small caps are the only inflation hedge you need. But they're an underappreciated one, especially when the market narrative is shifting. The Russell's six-point-three percent pop this week isn't a fluke — it's the market repricing a scenario where the economy keeps humming and inflation stays above target. Luna: And that repricing could continue if the next CPI print doesn't surprise to the downside. We get the May CPI on June tenth, right? Lucas: That's right. If it comes in hot again, we could see further rotation into cyclicals and small caps. If it cools, then the growth stocks might bounce back. But either way, the Russell's move this week is a signal that the market is broadening out. And for long-term investors, that's usually a positive development. Luna: So keep an eye on the Russell 2000 as a barometer for whether this inflation cycle is actually shifting investor behavior. And if you're rebalancing, don't ignore the little guys. Lucas: Worth noting: the Russell 2000 is up six-point-three percent in the past five days, but it's still down about four percent year-to-date. So there's room to run, but also a reminder that this is a volatile corner of the market. Not for the faint of heart. Luna: Good context. I think our listeners appreciate that you don't just hype the winners — you show both sides. Lucas: That's the whole point. Inflation is a persistent force, and the best defense is a portfolio that acknowledges uncertainty. Small caps can be part of that, but only if you understand the trade-offs. Luna: So to sum up: the Russell 2000's recent surge is a real signal of a market rotation tied to sticky inflation and a resilient economy. It's worth watching, and for some investors, worth a modest allocation. But it's not a slam dunk. Lucas: Perfect summary. Next time, we'll talk about how inflation is affecting municipal bonds — a topic that doesn't get nearly enough attention. Until then, keep your purchasing power front of mind.