Strong productivity growth, steady regional bank fundamentals and accelerating artificial intelligence adoption may be laying the groundwork for a more durable small-cap rally than investors have seen in years.
The small-cap benchmark – tracked by the iShares Russell 2000 ETF (NYSE:IWM) – has repeatedly pushed to record highs this month, outperforming large-cap indices — a rare dynamic after years of narrow market leadership dominated by mega-cap stocks.
Despite those gains, the macro and fundamental case for U.S. small caps "remains intact," according to a strategy note released Thursday by 22V Research, which argues the rally is being supported by longer-term structural forces rather than short-term positioning.
Productivity Is The Quiet Driver Behind Risk-On Momentum In Small Caps
"Strong productivity allows for above-trend growth without causing inflation," wrote Dennis DeBusschere, president and chief market strategist at 22V Research.
"That allows the Fed to keep financial conditions easy and favors risk-on versus risk-off exposure."
This backdrop, the firm argues, creates space for the Federal Reserve to remain patient, while markets focus more narrowly on labor market and services inflation data as the key determinants of policy risk.
Geopolitical volatility, including recent tariff headlines, has so far reinforced that view. According to 22V, those episodes have increasingly been treated by markets as opportunities to add risk rather than signals to de-risk.
Why Small Caps Can Keep Going
"The broadening-out of returns can last more than a month or two without being offset by tighter financial conditions," the firm wrote.
On a fundamental basis, small-cap earnings revisions are now outpacing both their historical norms and revisions seen in mid- and large-cap stocks — a trend 22V says is inconsistent with a late-cycle slowdown.
Importantly, small caps entered the year with depressed valuations after seeing "significant multiple contraction" in 2025, even as fundamental growth outpaced large caps.
Banks Quietly Signal Fading Recession Risk
Financials — particularly regional banks — have emerged as a key contributor to small-cap performance.
Bill Hebel, 22V's banks analyst, said fundamentals remain solid and valuations compelling.
"Regional Bank fundamentals have been solid this quarter and relative valuations are attractive," Hebel said.
He added that the market's rationale for paying a premium for larger balance sheets, capital markets exposure and card businesses has weakened, while earnings season commentary has offered a telling signal.
"There has been a notable absence of conversations about credit health in earnings so far," Hebel added.
AI Adoption Could Be The Next Re-Rating Catalyst
Artificial intelligence may represent the next leg of upside for small caps, particularly as adoption moves beyond software and into physical products.
Jordi Visser, 22V's AI specialist, said 2026 could mark a turning point.
"The integration of AI into physical products is the major investment theme of 2026," Visser said, pointing to power providers, semiconductors, capital goods and tech hardware as primary beneficiaries.
While small caps have historically lagged large caps in AI adoption, management teams are now increasingly referencing specific AI use cases on earnings calls.
"The re-rating is still in its early innings," Visser said, adding that AI adoption could help small caps close margin gaps that have favored large caps in recent years.
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