NEW YORK: The prospect of interest rates remaining elevated as the Federal Reserve battles inflation is further clouding the outlook for shares of smaller U.S. companies, which have lagged broader markets this year.

Small cap stocks surged at the end of 2023, as expectations grew that the Fed was done raising interest rates and would soon begin easing monetary policy. That would be a welcome change for smaller companies, which rely more heavily on debt financing and consumer spending.

But stubbornly strong inflation has eroded prospects of rate cuts this year, and small cap stocks have suffered as a result. The Russell 2000 is up just 0.4% year-to-date, far less than the S&P 500's 7.5% gain. Earnings are also expected to be shaky, giving investors little reason to shift allocations from larger companies and other, less risky parts of their portfolios.

"Investors are skeptical right now about small cap stocks because of higher rates and stickier inflation, and they need greater clarity that the Fed will be cutting rates this year before moving in," said Michael Arone, Chief Investment Strategist for State Street’s SPDR Business, who has been buying small caps in anticipation of rate cuts later in the year.

The case for smaller stocks may have improved over the last few days. U.S. employment data on Friday showed that jobs growth, while still relatively robust, slowed last month, easing fears that rates will remain elevated for the rest of the year. The Russell 2000 was up about 1% on the day.

On Wednesday, Fed Chairman Jerome Powell said he still believed rates were heading lower this year, despite stubborn inflation.

Futures markets on Friday showed investors pricing in around 45 basis points of interest rate cuts this year, from less than 30 priced in earlier this week. That remained far lower than the 150 points they had priced in January.

Stronger-than-expected earnings in coming weeks could help allay investor concerns. Overall, the Russell 2000 is expected to post earning growth of -8.4% over the most recent quarter, compared with a 10.2% earnings growth rate for the S&P 500, according to LSEG data. At the same, the Russell 2000 is trading at a forward price to earnings ratio of 22 compared with a 20 times earnings multiple for the S&P 500, making small-caps more expensive.

"The earnings pickup we expected has just not been there," said David Lefkowitz, CIO Head of US Equities at UBS Global Wealth Management, who has been overweight small caps since December. "I still think the preference for small makes sense, but it depends on your rate view."

Among the notable small cap companies reporting in the week ahead are nutrition company Bellring Brands, gambling company Light & Wonder and oil and natural gas company Permian Resources.

Larger caps reporting next week include Walt Disney, Wynn Resorts and Akamai Technologies, as US corporate earnings season continues.

Despite the encouraging developments of the last few days, few believe the path to rate cuts is clear.

Jill Carey Hall, equity & quant strategist at Bofa Global Research, said investors buying small caps should focus on companies positioned to withstand an extended Fed pause, including those with higher percentages of fixed dent and comparatively low leverage.

"It's too soon to price in more rate cuts," said Timothy Chubb, chief investment officer at Girard. "One number doesn't make a trend. Overall, the Fed is getting the evidence it needs.”

(Reporting by David Randall; Editing by Ira Iosebashvili and David Gregorio)