Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why Small Caps Are Surging While Big Tech Stalls
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- Lucas: The Russell 2000 just put up three point four percent in a single week. The S&P 500? One percent. The Dow did a little better at one point eight, but the story here is the small caps. Luna: That's a big gap. Is this the rotation people have been waiting for, or is it just a catch-up trade after small caps got hammered? Lucas: That's exactly the question. The Russell has been trailing for more than a year, so a snap-back was always possible. But three point four percent in five sessions — that's not nothing. And it comes at a moment when the macro picture is genuinely confusing. Luna: Speaking of the macro picture — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo to keep this show ad-free. And that's literally what funds making this many of these. Lucas: Yeah, it's a small group but it makes a real difference. No ads, no sponsors — just listeners who find the daily economics useful. If that's you, buy me a coffee dot com slash fexingo. Luna: Right. Anyway, back to the rotation question. Lucas: So let's anchor this in the numbers. The S&P 500 is at 7,473. That's up about 11 percent year to date. The Russell is at 2,869 — up only about 5 percent. So even after this week, small caps are still lagging by a wide margin. Luna: Right, so the gap hasn't closed. But the speed of the move makes you wonder whether something fundamental has shifted. Lucas: Exactly. And that's where the macro data comes in. The ten-year Treasury yield dropped to 4.56 percent this week, down about 1.4 percent on the week. Lower yields typically help small caps more than large caps because small companies carry more floating-rate debt. Luna: So the bond market is basically giving small caps a tailwind. Lucas: It is. But then you look at the economy itself. Real GDP growth annualized came in at 2 percent in the first quarter, up from 0.5 percent in the fourth quarter of last year. That's a decent acceleration. But the unemployment rate is at 4.3 percent — flat — and job openings are actually falling. JOLTS went from 6.9 million to 6.87 million. Luna: So the economy is growing but the labor market is slowing. That's not a classic recipe for a small-cap rally. Lucas: No, it isn't. Typically small caps need robust domestic demand and rising employment. What we have is a so-so economy with a Fed that's holding rates at 3.64 percent — flat — and no one quite knows when they'll cut. Luna: But the market is pricing in cuts, right? The bond market is. Lucas: It is. The ten-year breakeven inflation rate is 2.4 percent, which is actually up a tick from last week. So inflation expectations aren't falling — they're sticky. But the nominal yield is falling, which means real yields are coming down. That's a signal that the market expects the Fed to ease. Luna: And that would benefit small caps disproportionately because they're more sensitive to borrowing costs. Lucas: Exactly. But there's another angle here. The AI boom has been incredibly concentrated in a handful of mega-cap names. The top five stocks in the S&P 500 account for something like 25 percent of the index. Small caps have been completely left out of that narrative. Luna: So maybe this week is the market starting to price in that AI benefits are broadening out. Not just the chip makers and cloud giants, but the companies that actually use the technology. Lucas: That's a compelling theory. And there's some evidence for it. The headline on CNBC this week was literally 'The AI economy is rewriting the American Dream — and blue-collar workers are poised to win.' That suggests a narrative shift toward Main Street, not just Silicon Valley. Luna: But consumer sentiment hit a record low in May. That's the flip side. People are feeling the pinch from inflation, especially with the Iran conflict driving energy prices up. Lucas: Right. CPI came in at 332.4 in April, up from 330.3 in March. That's a 0.6 percent monthly increase, which is not trivial. Core CPI is even higher at 335.4. So the cost of living is still climbing. Luna: So you have this tension: the economy is growing, but consumers are miserable. And small caps are rallying anyway. Lucas: That's the puzzle. One way to resolve it is that the market is looking past the current inflation spike and focusing on the second half of the year. If the Fed does cut rates — say, in September or December — then small caps could be the primary beneficiary. Luna: But what if the Fed doesn't cut? The Fed funds rate is at 3.64 percent, and the interest on reserve balances is 3.65 percent. They're effectively on hold. Lucas: If they don't cut, then this rally could fade fast. Small caps are much more volatile. The Russell has a beta of something like 1.2 versus the S&P. So when the market turns, small caps get hit harder. Luna: So what's the catalyst this week that sparked the move? Was it the jobless claims number? Initial claims came in at 209,000, down from 212,000. Lucas: That probably helped. A declining trend in claims suggests the labor market isn't collapsing — it's just normalizing. That's the Goldilocks scenario: not too hot, not too cold. And small caps love Goldilocks. Luna: But we also had average hourly earnings ticking up to 37.4 from 37.35. That's wage inflation, which is good for workers but could keep the Fed cautious. Lucas: Yeah, that's the tricky part. Wage growth running at about 4 percent annualized is not compatible with the Fed's 2 percent inflation target. So even if the economy slows, the Fed might not cut because of wage pressure. Luna: So the small-cap rally might be a bit of a head fake. A lot of moving parts. Lucas: It could be. But let's look at valuations. The Russell 2000 trades at about 22 times forward earnings. That's roughly in line with its 10-year average. The S&P 500 trades at about 24 times, which is above average. So small caps are actually cheaper on a relative basis. Luna: So if you believe in mean reversion, small caps have more room to run. Lucas: Exactly. And that's the bull case here. The market is finally recognizing that the economy isn't falling into a recession — growth is running at 2 percent — and that small companies are undervalued relative to their larger peers. If that narrative sticks, we could see a sustained rotation. Luna: But the consumer sentiment data is a real warning. If people are feeling terrible, they stop spending, and that hits small businesses first. Lucas: That's the bear case. The record low in sentiment — driven largely by inflation fears tied to the Iran situation — could spill over into actual spending. And if that happens, small-cap earnings will disappoint. Luna: So you're saying the next few weeks of economic data are crucial. Lucas: Absolutely. If we get a strong retail sales number or a good consumer confidence print, the rally has legs. But if sentiment continues to deteriorate, this week could be a false dawn. Luna: It's interesting that the bond market is already pricing in a softer economy, but stocks are betting on a soft landing. Which one is right? Lucas: That's the million-dollar question. The yield curve is still inverted, which historically has been a reliable recession signal. But the stock market is saying no recession — just a temporary slowdown. Something has to give. Luna: And small caps are caught in the middle — they're the most sensitive to the outcome. Lucas: Exactly. They're the canary in the coal mine. If the Russell can hold above 2,800 and start to trend higher, that will tell us the market is buying the soft landing narrative. But if it gives back these gains, we'll know it was just a bear market rally in a lagging index. Luna: So what are you watching for next week? Lucas: I'm watching the weekly jobless claims and any Fed commentary. Also, oil prices — if they keep rising because of the Iran tensions, that will crush small caps, especially in sectors like transportation and manufacturing. Luna: And I guess we'll see if the AI narrative really does broaden out. Lucas: Right. If a small cap software company or an industrial firm starts talking about AI adoption boosting margins, that could be the catalyst for a real shift. But for now, it's still mostly a story about the mega-caps. Luna: Fair enough. So we're cautious but curious about this rotation. Lucas: That's the right stance. Acknowledge the data, but don't chase the move. If it's real, there will be plenty of time to get in. If it's not, you don't want to be holding the bag.