In the first half of 2023, U.S. small-cap stocks showed decent trends but lagged the S&P 500 (up about 16%) and the Nasdaq Composite (up about 31.7%). The small-cap Russell 2000, an index tracking U.S. small-cap stocks, saw modest gains of around 7.2% during that period.

While the past three months have been tough for the Russell 2000 index, as evident from losses of 9.2% seen in iShares Russell 2000 ETF (IWM Quick QuoteIWM - Free Report) , the pint-sized stocks should gain momentum in the final quarter of this year. We’ll tell you why.

IMF Boosts U.S. Growth Forecast

The International Monetary Fund (IMF) recently boosted the U.S. growth forecast for 2023 while keeping the global outlook unchanged. The U.S. growth projection for this year was raised by 0.3 percentage points from its July update to 2.1%. The IMF hiked next year’s forecast by 0.5 percentage points to 1.5%. For the Eurozone, the IMF cut the forecast by 0.2 percentage points to 0.7% for 2023 and by 0.3 percentage points to 1.2% for 2024, per CNBC.

Better-than-expected U.S. economic recovery is a plus for small-cap stocks. Since small-cap stocks are closely tied to the domestic economy, an uptick in economic outlook bodes well for small caps. These stocks are not heavily export-centric and, hence, do not get battered if the greenback rises.

Resilient U.S. Consumers

Despite sticky inflation, U.S. consumers have been showing strong resilience. Retail sales in the United States grew 0.7% sequentially in September 2023, following an upwardly revised 0.8% uptick in August and beating forecasts of a 0.3% advance. The data continues to indicate robust consumer spending despite high prices and borrowing costs. This is another positive for the small-cap space.

Geopolitical Tensions are Rife

The recent, brutal assault on Israel by Gaza-based Hamas has been hitting headlines lately. Another major concern is that Iran-backed Hezbollah in Lebanon, which shares a northern border with Israel, might step up attacks. Hezbollah is much more powerful and better equipped than Hamas (read: Defense Stocks & ETFs Soar Amid Rising Geopolitical Tensions).

Due to the Middle East tensions, safe-haven assets have jumped this month while defense stocks and oil have also rallied. If Iran escalates the war and Israel keeps fighting on several fronts, the global markets may face a chaotic situation in the ongoing fourth quarter. In this situation, pivoting toward domestic equities could prove to be an intriguing idea.

Greenback to Remain Strong Ahead?

Solid economic data points raise the odds of rate hikes in the Fed meeting in November. Additionally, inflation remains sticky, which will make it difficult for the Fed to cut rates anytime soon. This, in turn, should keep the greenback strong.

Invesco DB US Dollar Index Bullish ETF (UUP Quick QuoteUUP - Free Report) has added 1.3% past month and 8.1% in the past three months. With small-cap companies being more inclined to the domestic economy and having less foreign exposure, a stronger U.S. dollar is beneficial for the segment.

Time for Value ETFs?

Given this favorable yet edgy investing backdrop, investors can bet on small-cap value ETFs. After all, value investing requires buying securities that appear underpriced. Also, value stocks perform better in a rising rate environment.

Below, we highlight a few small-cap value ETFs that have fared better in the space in the past three months (as of Oct 17, 2023).

Invesco S&P SmallCap Value with Momentum ETF (XSVM Quick QuoteXSVM - Free Report) – Down 0.4%

Pacer US Small Cap Cash Cows 100 ETF (CALF Quick QuoteCALF - Free Report) – Down 0.7%

First Trust Small Cap Value AlphaDEX ETF (FYT Quick QuoteFYT - Free Report) – Down 1.3%

Avantis U.S. Small Cap Value ETF (AVUV Quick QuoteAVUV - Free Report) – Down 2.2%

Roundhill Acquirers Deep Value ETF (DEEP Quick QuoteDEEP - Free Report) – Down 2.7%