US economy in expansion phase: the BBVA US Macro Indicator was highlighting elevated recession risks at the start of 2Q, but the latest reading for July suggests that the US economy has entered the expansion phase. This was further evidenced during the most recent earnings season, with 80% of US corporates beating estimates. Our optimistic reading is in contrast with the latest jobs report, which showed muted job creation below market expectations. Nonetheless, the PMI reading and sticky wage data suggest supply rather than demand weakness in labour markets.

Loose getting looser: Fed’s latest cut points to a restart of cutting cycle, with more cuts to come. Furthermore, the fiscal stimulus facing the US economy from the “One Big Beautiful Bill” – which consensus expects will boost US GDP by up to 0.5% – and potentially tariff-funded fiscal cheques is likely to spur a continuation of risk-on sentiment. Cross-asset volatility has been on a downtrend since peak levels in April. We believe supportive fiscal policy combined with less restrictive monetary policy will keep financial conditions in check in the near term.

US economic growth helping earnings: the latest earnings season saw 80% of US large-cap equities beat analyst EPS estimates, one of the highest beat rate in recent cycles. Tech and communication services led the way (boosted by AI investment), while energy suffered large profits declines, largely due to weak oil prices. Tariffs remains a risk to profit margins; that said, soft labour market data combined with strong earnings point to a productivity boost for US corporate earnings for years to come. After tech, small-cap stocks delivered the best earnings revisions driven by a rebound in US economic activity following the Q1 lull. Looking ahead, US small-cap stocks are expected to see the highest earnings growth in the years to come. Small caps have suffered from higher-for-longer interest rates. As the Fed restarts its cutting cycle, we would expect corporate lending conditions to improve, helping to boost earnings for small-cap stocks.

Small things matter: The Russell 2000 index has underperformed MSCI US equity this year on the back of tech leadership and softening US growth amid tariff uncertainty since the start of the year. Looking back at 40 years of history, the “soft-landing” Fed cuts tend to drive small caps to outperform. Currently, markets are pricing three rate cuts of 25bp for this year and six cuts by the end of next year, with the Atlanta Fed GDPNow still pointing to 3% growth suggesting that the small-cap outperformance has further to run.

Implementation: given the stars are aligning for small caps to outperform, we see the Russell 2000 high vol index (40% volatility based on exponentially weighted moving average) as a better instrument to implement our bullish small-cap view. Episodes of Russell 2000 outperformance of the SPX have seen the Russell 2000 HV index deliver outperformance over the Russell 2000 index due to higher leverage. We saw this during 2016-18, in late 2019, 2021, 2024 and more recently since April as the US economy rebounded from a soft 1Q and the Liberation Day-driven sell-off.