The Royce Roundtable: US small-cap forecast—more volatility and cautious optimism

Portfolio Managers Chip Skinner and Jim Stoeffel and Assistant Portfolio Manager Kavitha Venkatraman join CEO and Co-CIO Chris Clark and Co-CIO Francis Gannon for our Royce Roundtable, a new feature that highlights the insights of our investment teams.

Why do you think there was a fairly wide range of returns for the major US indexes in 2Q25? For example, The Russell 2000 Index gained 8.5%, the Russell Microcap Index rose 15.5%, the large-cap Russell 1000 Index was up 11.1%, and the mega-cap Russell Top 50 Index advanced 13.8%.

Francis Gannon: I think the context is important. As frustrating as it’s been for small-cap specialists like us, the long cycle of mega- and large-cap leadership kept its streak alive through the end of June. In fact, the Russell 1000 and Nasdaq Composite, which was up 18.5% in the second quarter, both reached new all-time highs on 6/30/25, while the Russell 2000 remained shy of its previous peak on 11/25/24 and was down -10.1% from that peak through 6/30/25. With micro-caps, I suspect that their strength came in part from having such a difficult first quarter (-14.4% versus -9.5% for the Russell 2000) and in part because smaller growth stocks did particularly well.

Kavitha Venkatraman: I was surprised that small-caps were only down by that margin from their peak through the end of June, considering how disruptive the tariff announcements have been. Of course, we all knew tariffs were coming, but nobody was expecting the magnitude that the White House put forth. So, that’s another important context—we still have no idea when or how all these tariffs will be put in place, so I think the market’s reaction was actually pretty benign.

What factors drove small-cap results in 2Q25?

Chris Clark: In addition to growth doing better than value within small-cap, the highest returns in both the second quarter and off the small-cap low on 4/8 came from stocks with more debt, no dividends, no earnings, and low or no ROIC (returns on invested capital). So, it was a high-growth, low-quality rally—which is consistent with previous small-cap rebounds following corrections. And small-caps experienced a bear market—that is, a decline of 20% or more from a previous peak—from the Russell 2000’s peak on 11/25/24 through 4/8/25, when the Russell 200 fell -27.5%.

How much did volatility affect small-cap results in 2Q25?

Francis Gannon: There was an interesting dynamic in the quarter that we might characterize as the rise and fall of volatility. In other words, stocks were very volatile following ‘Liberation Day’ on April 2nd, when the markets cratered before beginning to steadily recover in May. Along with seeing heightened volatility from the VIX—the CBOE S&P 500 Volatility Index—we looked at the number of trading days when the small-cap index was up or down 1% or more. During April, 13 out of 21 days, or 62%, had moves of 1% or higher; in May there were only 7 of 21, and in June only 9 out of 20. So small-caps either showed higher-than-usual volatility or were comparatively placid during the second quarter.

Chris Clark: Related to Kavitha’s and Frank’s observations, we see that small-cap performance in the second quarter improved dramatically as volatility began to decrease. After bottoming in early April, the Russell 2000 advanced 24.0% through the end of June. And although both small-cap style indexes had impressive, double-digit returns, small-cap growth led. The Russell 2000 Growth Index climbed 27.7% over that same period while the Russell 2000 Value Index rose 20.2%. So, regardless of where one was invested within small-cap, performance was robust off the year-to-date low.

Do you anticipate similar levels of volatility for stocks in the second half of 2025?

Jim Stoeffel: I think we’re likely to see more volatility in the second half because the markets really can’t stand uncertainty. For all the pro-growth policies and relaxed regulations that are being proposed or have already been implemented, Trump’s second term has already created a lot of anxiety, mostly centering on tariffs. Going back to November, we knew that there would be Republicans in control of both Houses of Congress and the White House—which signaled stability. This isn’t about ideology as much as it is about giving investors a reasonably good idea of what the policy backdrop will look like going forward. Many investors, including me, felt confident that any tariffs would be used as a negotiating tactic. But the tariffs ended up being more significant and much more capricious, I think, than anyone was expecting, and that kind of uncertainty is bad for equities.

Chip Skinner: We got the ‘Trump Bump’ at the end of 2024, which was followed by the ‘Trump Dump’ that ran throughout the first quarter and into early April before stocks bounced back. We’re pleased that the markets stabilized and recovered, and we’re equally pleased that the economy continues to grow at around a 2% clip annually. But I think we’re likely to see more uncertainty in the second half of the year. Even if tariffs are eventually settled with our biggest trading partners—as they recently were with Vietnam—the negotiating process creates a lot of headline risk and breeds volatility. The ensuing anxiety will almost certainly have a negative impact on stocks. Investors seem a bit too complacent to me given the environment we’re in. For example, I was really surprised by the non-reaction to the United States bombing Iran’s nuclear research facility and Israel and Iran bombing each other. There are a lot of risks out there, and I don’t see the markets staying as placid as they’ve been over the last two months.

With so much uncertainty about the economy, what have you been hearing from company management teams?

Kavitha Venkatraman: Most of the management teams that we’ve been talking to expressed concern about not knowing what their industry is going to look like until there’s greater clarity about the economy. Their concerns are not limited to tariffs, although that’s obviously been part of the conversation. But the increasing demand for power and renewable energy sources, especially the power needed to run artificial intelligence (AI) data centers, is an area that we began investing in over the last couple of years. Those management teams have expressed concerns about whether or not tax credits for solar, wind, and other alternatives would survive in the new federal budget. Many of these stocks fell sharply throughout the budget process. So, now we wait to see how these companies adjust financially and operationally to their new situation. But the demand for more energy is acute, and that’s not going to change because of the new federal budget.

Chip, what themes and/or industries are you currently finding most attractive and/or interesting?

Chip Skinner: There are two areas that I believe have been working well so far this year. The first is companies involved in the nuclear renaissance. There haven’t been many new reactors completed since the early ‘90s, and it’s one of the rare areas that has some bipartisan support. President Trump is pushing for more capacity in the United States while Governor Hochul of New York is looking for a site to build a new plant. We believe companies may look to provide services and components for the repair and maintenance of existing plants because a lot of operators are trying to upgrade their plants to produce more power. Specialty pharmaceuticals is the other area. Innovations have been sparking growth most recently, including generic pharmaceuticals, specialty drug makers, and pharmaceutical distributors.

Another interesting area is defense, where the success President Trump seems to be having in convincing other NATO countries to pay more is encouraging European countries to spend more on defense and having an extended runway for growth, as the United States is allowing our allies to buy our defense technology.

Kavitha and Jim, how about you?

Jim Stoeffel: We’ve been looking at a few areas within health care, including medical technology and personalized medicine. These have been relatively more recent investments for us because the valuation metrics in the sector had been challenging for small-cap value investors like us until the last few years. Many companies had multiples that benefited from the 0% interest rate environment. Now that those days are in the rearview mirror, we’ve seen some opportunities in companies where the multiples screen better with our low price to book and price to sales screening criteria.

Kavitha Venkatraman: To Jim’s point, we’ve seen a lot of valuations in the broad healthcare space fall to levels we find attractive. Part of this had to do with biotech funding being cut back. Another part had to do with Trump’s election because during his campaign he was talking about price controls and tariffs. RFK Junior’s nomination to be Secretary of Health & Human Services was controversial. All of these in aggregate were negative for valuations. But when we began seeing these declines, we took a step back and asked, “What's happening with the fundamentals?” I can’t recall a period when we’ve seen this level of innovation in healthcare before. Some of this is related to AI, which is turbocharging much of the sector, but much of it has been around for a while. Jim mentioned personalized medicine, where we see innovation in diagnostic areas like biologics. AI is simply speeding up testing, especially with data processing, which is allowing companies to bring treatments and services to the market more quickly because the Food and Drug Administration approval process has been speeding up.

What are your outlooks for the rest of 2025?

Jim Stoeffel: I’m basically optimistic over the long run. There’s a ton of uncertainty over the short term, most prominently geopolitical risks and all the noise surrounding tariffs, even beyond any renewed extensions. If more extensions are offered, then there may be room for small-caps to run for a little while. If they’re not, then we’ll probably see a downturn as investors and management teams rush to recalibrate a new environment. But small-caps are relatively cheap and are less likely to be negatively impacted by tariffs than their larger counterparts, so I can definitely see some daylight for our holdings.

Kavitha Venkatraman: I see reasons for optimism as well as caution. On one hand, we’re facing a potential labor shortage because of US Immigration and Customs Enforcement crackdowns, which just causes more inflation. We also don’t know for sure if tariffs are going to be inflationary or deflationary, though the consensus is that they’re likely to be inflationary. We also have lower-income consumers weakening quickly. Along with that, we’re seeing an increasing number of student loan delinquencies. Wage garnishment on those loans begins at 270 days delinquent—and we're approaching that point on many of these loans. Along with higher mortgage rates, these developments argue for the Federal Reserve (Fed) to cut rates later this year. These can all be added to the unknowns we’ve been discussing. However, we’ve also seen a lot of our companies allocating capital in productive ways. Some are paying down debt to cut costs and boost cash flows. Many of them are buying back shares—we’re seeing a lot of repurchase authorizations. To the extent that they can do mergers and acquisitions (M&A), we’ve also seen some small deals, but not yet at a magnitude that has a marked impact on portfolio performance. But if the Fed lowers rates later this year, I think we’ll see an uptick in M&A activity.

Chip Skinner: I’m holding my breath on a lot of issues because of all the near-term uncertainty that we’ve been talking about. The market rally seemed to catch some investors by surprise, so a pause in small-cap performance seems likely, at least until we gain incremental data points from second-quarter earnings reports, and more importantly, second-half outlooks. But like Jim, I’m optimistic for the long term, based on the level of spending on innovations in the United States and elsewhere, which is creating new industries and corporate leaders. It increasingly looks like the advent of AI and machine learning will be looked back on as major technological breakthroughs on par with the introduction of the railroad, electricity, telecommunication, gene sequencing, and the internet.

Francis Gannon: A lot of small-caps stocks are just starting to emerge from a two-year earnings recession, which should help boost performance for an asset class that’s lagged large-cap for several years and currently faces low expectations. And previous low expectations and relatively underwhelming returns have often been opportune times to increase allocations. Historically, sitting on the sidelines during corrections or the early stage of rallies has carried a high cost. So, I share the sense of cautious optimism for the advantages of active, risk-conscious, small-cap investing for the long run.