With all the talk about tariffs potentially causing the U.S. economy to slip into a recession, it’s not surprising that small-cap stocks — a domestically focused asset class — are lower on a year-to-date basis. The average loss of 7.59% for the Russell 2000 and the S&P SmallCap 600 indexes exceeds the YTD loss of the S&P 500’s 3.30%.
That could be indicative of what some market observers are saying is a dueling scenario in the U.S. economy. On one hand, it’s possible a traditional, though moderate. recession materializes. On the other, the Federal Reserve could prevent that from happening by lowering interest rates. And that could potentially lift smaller stocks and ETFs such as the ALPS O’Shares US Small-Cap Quality Dividend ETF (OUSM).
Since the start of the year, OUSM has shown its mettle. It has handily outperformed the aforementioned small-cap benchmarks. OUSM’s relative YTD strength could be a sign that if smaller stocks rebound in earnest, the ETF could be more leader than laggard in that scenario.
Hoping for Fed Assistance
Smaller companies, including those residing in OUSM, are usually more dependent on the U.S. for earnings and revenue than large-cap firms. However, that doesn’t imply tariff immunity. If trade levies punish the world’s largest economy, it’s difficult to envision a scenario in which small-caps aren’t taxed.
On the bright side, inflation expectations are declining. That could pave the way for the Fed to lower rates. And that could be an assist for ETFs such as OUSM.
“Even so, to date, interest rate futures are pricing in four cuts in the fed funds rate by the end of 2025. Implied inflation expectations (as per one-year breakeven inflation rates) have fallen by more than 1% to 3.05% from their peak earlier this year,” noted Vincent Nichols of BNP Paribas. “This indicates that market concern over the economy is trumping worries over an inflationary spike.”
In fact, OUSM could be among the small-cap ETFs most levered to easing monetary policy. That’s due to the fund’s nearly 23% weight to financial services stocks, its largest sector allocation. Smaller banks, including some held by OUSM, would likely restrict consumer and business lending if the U.S. economy contracts in earnest.
Myriad Benefits of Lower Interest Rates
“Lower interest rates alone should help improve stagnant loan growth, lower the country’s fiscal burden, similarly reduce interest expense for companies (especially smaller companies), and revitalise already depressed merger & acquisition activity,” added Nichols.
Nichols also points to the possibility of broadening in earnings per share growth in the U.S. market. That would be supportive of small-caps, including OUSM member firms.
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VettaFi LLC (“VettaFi”) is the index administrator and calculation agent for OUSM, for which it receives a fee. However, OUSM is not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of OUSM.
