Small-cap stocks have achieved their strongest first-half performance in decades, with the Russell 2000 index climbing approximately 22% in the first six months of the year. This surge marks a significant turnaround after years of underperformance compared to large-cap peers, with the first half of 2026 being its best since 1991. The rally is largely attributed to the expanding AI investment boom, as demand trickles down from leading tech companies to a broader network of suppliers.
The AI investment is particularly impacting semiconductor and semiconductor-equipment companies within the small-cap segment. These chip-related firms account for 16 of the Russell 2000's top 50 performing stocks this year, with some, like Aehr Test Systems, Ichor Holdings, and MaxLinear, rallying over 400%. Analysts, such as Amy Zhang from Alger, note that while AI is a significant driver, the rally is also supported by a “valuation catch-up story” and improving fundamentals across small-cap companies, leading to a broadening trade.
Despite the strong performance, Goldman Sachs warns that the rally may fade, projecting low single-digit Russell 2000 returns over the next 12 months. This caution stems from elevated valuations and budding risks, particularly rising monetary policy risks. The Federal Reserve's potential interest rate hikes pose a significant threat to small-cap companies, many of which have floating-rate debt. Approximately 30% of Russell 2000 debt is floating rate, compared to 7% for the S&P 500, making small caps more vulnerable to increased borrowing costs. Bank of America estimates that every 25-basis-point rate hike could reduce Russell 2000 operating earnings by about 2%.
Adding to the concerns, the Russell 2000's recent reconstitution in June 2026 halved the weight of its AI infrastructure stocks from 15% to 7%. This is notable given that about a quarter of the Russell 2000's constituents, representing 23% of its market cap, are unprofitable, a share that has trended higher over the past 20 years. Despite a recent tepid jobs report, markets are still pricing in a roughly 30% chance of a Fed rate increase by July 28-29, and over a 60% probability of at least one quarter-point hike by September, which could disproportionately impact the more rate-sensitive small-cap sector. However, some investors believe the worst of the tightening cycle might be over, with cumulative rate hikes of 500 basis points already implemented between March 2022 and mid-2023.
