Small cap momentum moderates

Key takeaways

• Small cap outperformance narrows as caution rises
• U.S. inflation steady; energy poses near-term risk
• Central banks expected to hold rates steady next week

Market leadership shifted modestly this week, with the performance gap between small cap and large cap stocks narrowing.

Earlier this year, the Russell 2000 Index outperformed the large cap S&P 500 Index by as much as 8 percentage points. As of March 12, that gap had narrowed to roughly 3%.

A likely driver has been increased investor caution amid developments in the Middle East. Periods of heightened uncertainty typically weigh more heavily on small cap stocks, which tend to be more economically sensitive and more volatile than their large cap counterparts.

That said, we remain broadly constructive on the outlook for small caps in 2026. Valuations remain compelling. Small cap stocks — particularly in the U.S. — continue to trade at a meaningful discount relative to large caps. In addition, our baseline outlook still calls for solid U.S. economic growth. Historically, firm economic growth has provided a tailwind for small cap equities.

In our view, maintaining exposure to small caps remains an important component of a diversified equity allocation.

This week brought inflation updates from both the U.S. and China. In the U.S., consumer inflation came in exactly in line with consensus expectations:

Headline CPI: 2.4% year-over-year

Core CPI: 2.5% year-over-year

Beneath the surface, the report showed encouraging details. A combined measure of wage-sensitive and shelter inflation moderated compared to January. Core inflation held steady at 2.5% largely due to pressure from more volatile components, such as airfare.

Looking ahead, recent increases in energy prices tied to Middle East developments could present a near-term challenge for the Federal Reserve. While energy prices directly affect headline inflation, sustained increases can also feed indirectly into core inflation. For example, higher fuel costs can push up transportation prices, including airfares.

Even so, over the medium term, we continue to expect the Fed will make further progress in its inflation fight.

In China, inflation came in slightly above consensus expectations. However, given that investor concerns in China have centered more on deflation risks than overheating inflation, the modest upside surprise is not particularly troubling.

Recent growth data has also shown improvement, with both exports and imports rising meaningfully year-over-year. While structural headwinds remain — including property sector weakness and elevated youth unemployment — we expect policymakers to continue supporting growth in pursuit of their stated 4.5%–5% GDP target for 2026.

Attention now turns to next week’s central bank meetings, with the Federal Reserve, the Bank of Canada and the Bank of Japan all set to announce policy decisions.

All three central banks are widely expected to leave policy rates unchanged. The more important focus will be on forward guidance — specifically, how policymakers assess the inflation outlook and evolving economic conditions.

Our baseline expectations:

Federal Reserve: Likely to remain gradual and data-dependent. One rate cut later this year remains possible, though continued economic strength could result in no cuts at all.

Bank of Canada: The bar for rate cuts remains high, but economic uncertainty and labor market pressures could create scope for easing later in the year.

Bank of Japan: We expect gradual rate hikes over time, but policymakers are likely to proceed cautiously to avoid tightening too quickly.

As markets digest incoming inflation data and geopolitical developments, central bank communication will play a critical role in shaping expectations for the remainder of 2026.