The small-cap index Russell 2000 recently witnessed its most impressive week in over two years as investors bet on the Federal Reserve's halt in its interest rate hike cycle. The space struggled in the past six-month period as evident from 1% loss compared with 5.6% gains in the S&P 500. However, tables seem to be turning for pint-sized stocks. 

The group should gain momentum in the final days of this year. Lori Calvasina, RBC Capital Markets Head of US Equity Strategy, believes that small-cap stocks present opportunities. These stocks tend to lag late in economic cycles and hence it makes sense to go bargain hunting in the small cap space in particular Calvasina told Yahoo Finance Live on Monday.

After all, October jobs data came in at weak. Unemployment is at its highest level in nearly two years. This may indicate dark times awaiting us ahead. We may be headed for economic slowdown in 2024. Hence, let’s delve a little deeper what are the tailwinds for small-cap Investing.

Fed Done Raising Rates?

The bets that the Fed is done raising rates strengthened on softer jobs data for the month of October. The Fed announced on Nov 1, 2023, that it would keep its benchmark interest rate within the range of 5.25% to 5.50%. Though the central bank has left the door open for potential future actions as it continues to grapple with the sticky inflation, the bets over such hawkish steps weakened lately.

CME FedWatch tool revealed that there is 87.6% chance of the rates remaining same in December (at the time of writing) and 82.2% chance that the Fed will again stay put in late-January (read: Housing Stocks & ETFs Will Likely Surge: Here's Why).

Don’t Fear Debt Concerns of Small-Caps

One of the reasons for the recent underperformance of small-cap stocks has been their relatively high debt levels compared to larger companies, per Lori Calvasina of RBC Capital. However, all of this debt is set to mature in the near term. Calvasina points out that RBC's research indicates that about 40% of the small-caps’ debt is scheduled to mature over the next two to five years. This means small-caps may adapt to evolving interest rate environments, especially given that the Fed may begin cutting interest rates at some point in 2024.

Interest Rate Outlook and Historical Comparisons

Lori Calvasina also draws attention to the broader interest rate environment and indicated that even if interest rates rise somewhat, they are rising from a much lower baseline than in past economic cycles. This aspect is often overlooked.

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 war between Gaza and Israel has been hitting headlines. Another major concern is that Iran-backed Hezbollah in Lebanon, which shares a northern border with Israel, might step up attacks. Due to the Middle East tensions, safe-haven assets have jumped last month. If the war is not contained soon, 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.

Cheaper Valuation of Small-Caps

The Russell 2000 hasn't been this cheap compared to the S&P 500 since the tech bubble in the late 1990s into the early 2000s, per RBC Capital, as quoted on Yahoo Finance. As a result, investors can bet on small-cap value ETFs that have lower P/E than the S&P 500’s P/E of 17.86X.

iShares US Small Cap Value Factor ETF (SVAL Quick QuoteSVAL - Free Report) – 8.30X

The underlying Russell 2000 Focused Value Select Index measures the performance of small-capitalization U.S. companies with prominent value factor characteristics.

Royce Quant Small-Cap Quality Value ETF (SQLV Quick QuoteSQLV - Free Report) – 9.54X

The fund looks to focus on high quality, U.S.-traded small-cap stocks with relatively low valuations. The fund uses a proprietary, multi-factor scoring system that emphasizes high profitability companies (Quality) selling at attractive valuations (Value).

Invesco S&P SmallCap 600 Pure Value ETF (RZV Quick QuoteRZV - Free Report) – 10.73X

The underlying S&P SmallCap 600 Pure Value Index measures the performance of securities that exhibit strong value characteristics in the S&P SmallCap 600 Index.

Vanguard Small-Cap Value ETF (VBR Quick QuoteVBR - Free Report) – 11.40X

The underlying CRSP U.S. Small Cap Value Index measures the investment return of small-capitalization value stocks.

ProShares Russell 2000 Dividend Growers ETF (SMDV Quick QuoteSMDV - Free Report) – 17.34X

The Russell 2000 Dividend Growth Index targets companies that are currently members of the Russell 2000 Index and have increased dividend payments each year for at least 10 years.