A surprise contraction in US payrolls has boosted small-cap stocks and reduced expectations for a September Fed rate hike. However, the upcoming CPI report is crucial for determining the sustainability of this rally, as small caps are highly sensitive to interest rates and inflation.
The unexpected contraction in US nonfarm payrolls by 23,000 in July, against forecasts for an 83,000 gain, has led to a significant rally in small-cap stocks, as evidenced by the iShares Russell 2000 ETF (IWM) outperforming the S&P 500 and Nasdaq 100. This data point has also caused futures traders to abandon bets for a September Federal Reserve rate increase, providing a temporary reprieve for interest-rate-sensitive small caps. However, the sustainability of this rally hinges on Wednesday's CPI report, as small-cap companies are structurally more vulnerable to interest rate changes due to higher interest expense relative to earnings. A benign CPI report could reinforce the 'soft-landing' narrative and support small caps in the short term, but a higher-than-expected inflation reading could quickly reverse their gains, posing a significant risk for traders betting on continued small-cap outperformance.