Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Small Caps Surge While Large Caps Slump What It Signals
Transcript
- Lucas: The Russell 2000 is up 2.4 percent over the past five trading days. The Nasdaq is down 2.1 percent over the same stretch. That is a pretty dramatic divergence, and it is the kind of move that gets my attention because it is not just noise — it is the market rotating into something specific. Luna: Small caps usually lead on the way up and lag on the way down. So seeing them outperform while large tech is selling off — that is a bet on the domestic economy, not a flight to safety. Lucas: Exactly. And it lines up with some of the real-economy data we have been watching. Job openings in April jumped to 7.6 million, up from 6.9 million in March. That is a big one-month spike. If companies are posting more jobs, they are expecting demand to hold up. That is a pro-cyclical signal. Luna: But then you have the factory layoff story. S&P just reported that factory job cuts in June are approaching levels we saw in 2008 and during Covid. That is the opposite of a hiring boom. Lucas: Right, and that is the tension. On one hand, the service sector is still adding jobs — leisure and hospitality, health care, government. On the other hand, manufacturing is clearly struggling. The ISM manufacturing PMI has been below 50 for months. So you have a two-track economy, and small caps are more exposed to the domestic consumer and services, less to global trade and manufacturing. That might explain the rotation. Luna: But what about the bond market? The 10-year breakeven inflation rate dropped to 2.18 percent on June 24, down from 2.21 percent. That suggests the market expects inflation to keep cooling. If the Fed sees that, they might feel less pressure to hike. Lucas: The fed funds rate is at 3.63 percent, and the interest on reserve balances is 3.65 percent. So the policy rate is roughly where it has been since May. But the bond market is pricing in a cut later this year. The 2-year note yield is around 3.69 percent, so the yield curve is still inverted, but less deeply than it was a few months ago. That is usually a recession signal, but the equity market is saying 'no recession yet' by rotating into small caps. Luna: So the stock market and the bond market are telling different stories. Which one do you trust? Lucas: Historically, the bond market has been better at predicting recessions. But equity rotations like this one — small caps leading — have often happened in late-cycle environments. Think 1999, 2006, 2018. The economy is still growing — real GDP growth annualized was 1.6 percent in Q1 2026, up from 0.5 percent in Q4 2025. That is not a recession. But it is slow growth, and the labor market is showing cracks in manufacturing. Luna: And the unemployment rate is 4.3 percent, which is low by historical standards. So the overall picture is: slow growth, low unemployment, but manufacturing weakness, sticky core inflation, and a Fed that is stuck at 3.63 percent. Small caps might be pricing in a soft landing. Lucas: If it was worth a coffee to you, honestly, that is the link — buy me a coffee dot com slash fexingo. We keep this show ad-free and that is only possible because listeners like you chip in. No pressure, just if today's conversation made something click. Luna: Yeah, it really helps us keep going. And we appreciate every single one who does. Lucas: So back to the rotation — the Russell 2000 has a lot of financials, regional banks, real estate, consumer cyclicals. Those sectors benefit from a steepening yield curve and stable to lower rates. If the Fed does cut later this year, small caps could see a tailwind. Luna: But if the recession that the bond market is signaling actually hits, small caps tend to get crushed. They are more leveraged, more sensitive to credit conditions. The Fed's rate is at 3.63 percent, and small business lending is already getting squeezed. Lucas: That is the risk. The high-yield credit spread is still relatively tight, but it has widened a bit in the last month. If the recession narrative intensifies, the rotation into small caps could reverse quickly. For now, the market seems to be saying 'the economy is okay, but not great, and the Fed will help.' Luna: One more data point: average hourly earnings rose to $37.50 in May, up from $37.41. That is a 2.9 percent annualized increase. Wage growth is moderating, which is good for inflation, but it also means consumers have less purchasing power. That matters for small caps. Lucas: It does. So the bull case for small caps is: the Fed cuts, the economy avoids recession, and domestic demand stays resilient. The bear case: the recession arrives, credit conditions tighten, and small caps sell off more than large. Which scenario is more likely? I lean toward the soft landing, but I think the next few weeks of data — especially the July jobs report and the next CPI print — will be decisive. Luna: And the Fed meeting in July? The market is pricing in about a 40 percent chance of a cut. If they hold, that could spook the small-cap rally. Lucas: Agreed. If the Fed stays on hold, the bond market might start to question the soft landing. But if they signal a cut, you could see the Russell 2000 break out further. For now, the outperformance is a vote of confidence in the domestic economy, but it is a fragile one. Luna: Alright, so we will be watching the Russell and the 10-year breakeven closely. Thanks Lucas. Lucas: Thanks Luna. And as always, thanks to everyone listening. We will be back tomorrow with more.