A Federal Reserve focused on supporting the economy through rate cuts is a robust bullish catalyst for U.S. small-cap stocks, according to Sean Gallagher, global head of Lazard’s small-cap equity platform.
In an exclusive interview with Benzinga, Gallagher reaffirmed his strong optimism that small caps will close the performance gap with large caps that has widened in recent years.
“The Fed is in ‘pro-growth mode,’ and easing financial conditions are very helpful for many parts of the economy,” he stated.
“I think laggard areas like small caps are a lot more attractive.” While Gallagher noted that the broader market isn’t cheap—given that the S&P 500 trades at over 20 times its earnings—small caps remain comparatively undervalued, trading at half the S&P 500’s price-to-earnings ratio.
Following the Fed’s bold decision to slash rates by 50 basis points to 4.75-5%, the Russell 2000, as tracked by the iShares Russell 2000 ETF (NYSE:IWM), had a volatile reaction on Wednesday, closing flat for the day.
Yet, as investors digest the decision, small caps rose by 1.7% on Thursday, outperforming larger-cap counterparts.
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Gallagher reiterated his call of “at least 30% upside on a 12 month basis,” for the Russell 2000.
“There’s no question” that even the group of non-earners within the small-cap index could benefit significantly from aggressive rate cuts, such as the 50 basis point reduction, he added.
As we enter what he describes as “a pretty aggressive rate-cutting cycle,” the market could expand beyond the heavily concentrated Magnificent Seven, bringing small caps into focus for retail investors.
The expert maintains a constructive outlook on the economy, dismissing fears of a slowdown. While he acknowledges some labor market softness, he doesn’t view it as a sign of fundamental weakness.
Fed To Cut By 25Bps At Every Meeting
Gallagher anticipates 25 basis point rate cuts at each upcoming Fed meeting. “We’re in a much better place with inflation and are gradually getting back to trend,” he said.
He foresees a steady series of 25 basis point cuts following the initial front-loaded 50 basis point cut.
“I think we’re in a ‘good is good and bad is bad’ kind of mindset going forward,” Gallagher said. Positive economic data will benefit the markets, whereas negative data, particularly on the labor market front, may disappoint investors.
Small Caps Poised To Play Catch-Up, Biotech In Focus
Gallagher believes cyclical sectors are set to rise here.
He is particularly optimistic about companies with lean inventories, solid balance sheets, and free cash flow, especially those enduring the current tough cycle. “When demand comes back, you’ll see meaningful appreciation,” he said.
Gallagher also sees potential in the biotech sector, noting that higher rates have been restrainting funding for years.
“We're definitely active in healthcare, looking for opportunities with companies that have diversified pipelines, solid balance sheets, and are poised to benefit when biotech funding picks up,” he added.
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