Small-Cap Lag: Navigating Tariff Impacts and Interest Rate Reductions

Trade Disruption: Tariffs Hit Small Businesses

Trade between the U.S. and China has been sharply disrupted. Following a dramatic tariff increase of 145 percentage points in early April 2025, American imports from China dropped in May to roughly half of what they were at the beginning of the year. This decline surpassed the contraction seen during the initial COVID-19 outbreak, highlighting how unpredictable policies can severely hinder international commerce.

This abrupt halt in trade is putting significant financial strain on small companies. According to the Federal Reserve’s 2025 Small Business Credit Survey, over 40% of small firms reported that increased tariff-related expenses created financial difficulties. With limited ability to raise prices, 76% of these businesses passed some of these higher costs onto their customers, which squeezed profit margins and dampened consumer demand.

The situation is expected to worsen. As the government extends tariff deadlines and negotiates new agreements, the average effective tariff rate is projected to climb to between 15% and 20% by the end of the year. This would mark the highest level in over a century, creating a lasting cost burden for small-cap companies that depend on imported materials and domestic pricing flexibility.

Market Dynamics: The Role of Rate Cuts

Support from the Federal Reserve has been crucial for the resilience of small-cap stocks. The central bank lowered its benchmark interest rate by 1% in 2024 and an additional 0.5% in 2025, ushering in a period of low borrowing costs that directly benefits smaller, credit-reliant businesses. This monetary easing has already had an impact, with the Russell 2000 small-cap index rebounding 13% so far this year.

However, this recent uptick masks a longer period of weak performance. Small-cap stocks have lagged behind for five straight years, and the Russell 2000 entered correction territory in early 2025. The current rally is largely a reaction to the Fed’s actions rather than a sign of a fundamental turnaround in the sector’s long-term trend.

This support is now at risk. The Federal Reserve has delayed further rate reductions for nearly a year, citing concerns about inflation driven by tariffs. Without additional easing, the main driver behind small-cap outperformance is threatened, as ongoing cost pressures from trade policy continue to weigh on these firms.

Key Drivers and Threats: Breaking the Stalemate

The most important factor that could relieve current pressures is a sustained reduction in the average effective tariff rate. The anticipated 15% to 20% rate by year-end would be the highest since the early 20th century, representing a direct cost shock for small businesses. A reversal—whether through successful trade negotiations or policy de-escalation—would lower input costs and ease the uncertainty that has stalled imports and investment.

The main risk is that this uncertainty continues. With ongoing delays and new deals announced by policymakers, the environment remains unpredictable. This persistent ambiguity hampers business planning and capital investment, extending the period of underperformance for the sector. As a result, the movement of goods and capital remains restricted, blocking a true recovery.

Ultimately, monetary policy remains the decisive catalyst. Additional rate cuts from the Federal Reserve would lower financing costs for small businesses facing capital constraints. This would provide the liquidity needed to counteract tariff pressures, serving as a crucial support to help small-caps break out of their current slump.