Small cap momentum moderates

Transcript

Hello everyone and welcome to market weekend review for the week of March 13, 2026. My name is Beay Chan Linn. I'm a director and head of Canadian investment strategy here at Russell Investments. Today we'll be talking about small cap stocks, inflation data, and finally we'll wrap up with a preview of central bank decisions. So let's get started. First, you might have noticed a narrowing of the performance gap between small cap and large cap stocks. At one point this year, the Russell 2000 small cap index outperformed the large cap S&P 500 index by as much as 8 percentage points. But more recently, that gap has been narrowing. As of March 12th, that gap has narrowed down to around only 3%. So, what's been driving that? From our perspective, one of the potential drivers has been an increase in investor caution as a result of the developments in the Middle East. Generally speaking, when you see investors become a little bit more cautious, small cap stocks are a little bit more susceptible compared to large cap stocks. Nevertheless, though, we are still broadly speaking optimistic about the outlook for small cap stocks in 2026. When you look at the valuation gap, small cap stocks are still trading at a significant discount to large cap stocks, particularly when it comes to US small cap. In addition, notwithstanding the developments in the Middle East, generally speaking, we are still optimistic about the US growth forecast in our baseline scenario. And generally speaking, strong economic growth translates into a tailwind for small cap equities. So, we continue to think that having exposure to small cap in a portfolio can still be crucial for investors. Next, let's transition to talk about the inflation data. This week, we got inflation data from both the US and China. On the US side of the spectrum, we saw consumer inflation come in exactly in line with consensus expectations. Headline inflation came in at 2.4% year-over-year. core inflation came in at two and a half% year-over-year. When we look underneath the surface of the report, we see some even more encouraging signs. If we focus in on the combination of wage sensitive and shelter inflation, we saw that the combination of those two components actually moderated compared to their year-over-year inflation pace in January. So the only reason why overall core inflation did not moderate from 2 and a.5% in January to an even lower number in February is because of some pressure coming through from volatile items like airfare. Now as we look ahead to the upcoming few months, we might see a little bit of a setback in the Fed's inflation fight because recently we've been seeing some increases in energy prices as a result of the developments in the Middle East. Now, energy prices can feed into higher headline inflation, but if we get sustained elevated energy prices, we might also see a little bit of a feed through in core inflation as well. And that's because even though core inflation excludes the direct impacts of higher energy prices, they don't exclude the indirect impacts. And so if airlines start charging more to offset fuel costs, then you could see a little bit more of a pass through effect there as well. Nevertheless, though, as we look ahead over the medium-term, we still expect the Federal Reserve to be successful in their fight against inflation. Meanwhile, if we look at what's going on in China, we saw inflation numbers there come in a little bit hotter than consensus expectations. But given that in China, more people had been worried about the potential for deflation rather than the potential for inflation running above target, we don't think it's a worrying sign for inflation to come in a little bit hotter than consensus expectations. In addition, when we look at some of the recent growth data, we've also been seeing some encouraging signs in China as well, where both exports and imports increased significantly year-over-year in the latest data. Nevertheless, China does continue to face some economic headwinds in the form of property sector weakness and elevated youth unemployment rates. But we do think the Chinese government will continue to do what it takes to be able to meet that goal of between 4 and a half to 5% GDP growth that it had set out at the 2026 two sessions meeting. Finally, we'll end with a preview of central bank meetings. Next week, we'll get the Federal Reserve meeting, the Bank of Canada meeting, as well as a Bank of Japan meeting, all taking place next week. And all three central banks are expected to leave interest rates unchanged at this upcoming meeting. But what's more important to focus on will likely be how the chairs or governors or heads of those respective central banks view the inflation trajectory from this point forward and how they talk about the developments in the economy as it relates to whether that will change their forecast of inflation and growth. Ultimately our baseline scenario is we expect the Federal Reserve will be very gradual with rate cuts this year. They might do one cut later this year or they might not even do any cuts at all given the strength of the US economy. For the Bank of Canada, we do think that there's a high bar for rate cuts, but given the uncertainty in the Canadian economy and given some of the pressures we've been seeing in the labor market, there could still be the potential for more rate cuts at a later date this year. And finally, with the Bank of Japan, we expect that over time, gradually, they'll be raising interest rates, but we also think they'll be cautious about raising interest rates too quickly because they don't want a repeat of what happened in 2024. That's all from us at Russell Investments for this week's market weekend review. Thanks so much for tuning in and we'll see you next time. >> Hi, I'm Sophie Antaly, head of portfolio and business consulting at Russell Investments. If you liked what you just saw and heard, consider subscribing to our YouTube channel or check us out on LinkedIn. Thanks for tuning in.

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

Small cap performance moderates

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.

Inflation data

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.

Central bank decisions ahead

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.

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