Small-cap stocks enjoy their best first half in 35 years. Here's what's driving it

• Semiconductor companies dominate the rally, with 16 of the Russell 2000's top 50 performers being chip-related firms, some gaining over 400% as AI spending trickles down the supply chain
• Consensus earnings growth forecasts for Russell 2000 companies in 2026 have jumped to 38% from 23% at year-start, reflecting broadening profit growth beyond mega-cap tech
• Higher interest rates pose the biggest risk, as each 25-basis-point hike could reduce Russell 2000 operating earnings by 2%, with markets pricing 60% probability of rate increases by September

Summary: Small-Cap Stocks Post Best First Half Since 1991

The Russell 2000 Index has surged over 21% in the first half of the year, marking its strongest performance since 1991 after years of underperformance versus large-cap stocks.

Key Drivers:

The rally is driven by both valuation catch-up and improving fundamentals. Unlike typical small-cap booms tied to economic cycles, this surge is fueled by AI infrastructure buildout spreading beyond major tech companies to smaller suppliers.

Semiconductor and chip equipment companies dominate the gains, with 16 of the Russell 2000's top 50 performers coming from this sector. Multiple companies have rallied over 400%, benefiting from trickle-down effects as chipmakers and cloud providers increase AI infrastructure spending.

Market Implications:

Consensus earnings growth forecasts for Russell 2000 companies in 2026 have jumped to 38% from 23% at year-start, signaling broadening profit growth beyond mega-cap tech. Additional catalysts include:

• Greater exposure to the U.S. economy
• Expected increased M&A activity, particularly in pharma and biotech
• Tax incentives for capital investment

Key Risk:

Higher interest rates pose the biggest threat. The Federal Reserve meets July 28-29, with markets pricing a 30% chance of a rate increase and over 60% probability of at least one hike by September. Small-caps are particularly vulnerable due to higher floating-rate debt exposure—Bank of America estimates each 25-basis-point hike would reduce Russell 2000 operating earnings by approximately 2%.

However, many investors believe the worst of the Fed's tightening cycle (500 basis points since March 2022) is over, with expectations that inflation and rates have peaked.