Small-Cap ETFs Face Wild Volatility Amid Trump Presidency and Market Shifts

The first two weeks of 2025 have been turbulent for small-cap exchange-traded funds (ETFs). After a steep selloff driven by rising Treasury yields and fears of delayed Federal Reserve rate cuts, small-cap ETFs staged a dramatic comeback following a tame consumer price index (CPI) report.

The iShares Russell 2000 ETF (IWM), which tracks 2,000 smaller companies in the Russell 3000 Index, dropped 3.4% last week before rebounding 3.5% this week. This marked its best performance since November 2024, though the rollercoaster ride has left investors wondering about the broader trajectory for small-cap stocks.

The Drivers of Small-Cap Volatility
The sharp swings in small-cap ETFs reflect the sensitivity of these stocks to interest rate changes:
-Many small-cap companies are highly leveraged, meaning their future cash flows are heavily impacted by  changes in borrowing costs.
- Stronger-than-expected jobs data last week spooked investors, raising fears that the Fed might slow or pause rate cuts, which are seen as crucial for small-cap performance.
Philip Greenblatt, portfolio manager at Easterly Investment Partners, noted:

“When interest rates appear to come down, small caps rally aggressively because their valuations depend on a lower discount rate.”

Policy Tailwinds Under Trump
The return of Donald Trump to the White House has fueled speculation that his pro-growth and pro-business policies could benefit domestically focused small-cap companies. Investors expect tax relief, reduced regulations, and support for reshoring supply chains to disproportionately boost smaller firms compared to multinational corporations.

Gregory Spiegel, a portfolio manager at Neuberger Berman, highlighted the potential for a “reshoring renaissance,” stating:

“Smaller companies, which generate most of their revenue domestically, stand to benefit the most from Trump’s focus on reindustrializing America.”

Risks and Opportunities
While Trump’s policies may provide a long-term boost, short-term risks persist. Investors remain focused on the pace of rate cuts and the possibility of inflationary pressures, which could affect valuations. Greenblatt suggests that active management and a value-oriented approach could be crucial for navigating this environment.

Spiegel also noted that small caps could benefit from structural shifts, including a return to U.S.-based manufacturing, which could enhance capital allocation and cash flows for smaller firms.

Looking Ahead
As small-cap ETFs continue to see heightened volatility, investors are weighing the potential for sustained growth under Trump’s administration against ongoing macroeconomic risks. For now, the outlook for small caps remains tied to both fiscal policy and the Federal Reserve’s decisions in 2025.