Why Russell 2000 ETFs Win Amid Tariff De-Escalation

Russell 2000 ETFs, such as the iShares Russell 2000 ETF (IWM), have outpaced the broader U.S. equity market following this week’s U.S.-China tariff pause and the general trade war de-escalation over the past month.

On Monday, the Russell 2000 index climbed 3.5%, edging out the S&P 500’s 3.3% gain, reflecting renewed investor optimism in small-cap stocks.

This positive movement is attributed to the 90-day truce between the U.S. and China, which involved significant reductions in reciprocal tariffs.

Since the bottom of the near-bear-market decline of 19% April 8, IWM has jumped 20%, whereas the S&P 500 has gained 18%, primarily led by mega-cap tech stocks.

Small-cap companies, which are more domestically focused, are particularly sensitive to changes in trade policy. The reduction in tariffs lessens input costs and supply chain disruptions, directly benefiting these businesses. Additionally, the truce improved overall market sentiment, encouraging investors to shift towards riskier assets like small-cap equities.

This shift is further supported by a decrease in recession probabilities, with betting markets lowering the odds of a U.S. recession from 52% to 40%.

The rally in small-cap stocks was further amplified by a short squeeze. Prior to the trade truce, small- and mid-cap stocks had higher short interest, with 6.3% of shares shorted compared to 1.8% for large-cap stocks.

The sudden positive shift in trade relations forced short sellers to cover their positions, driving prices even higher.

Looking ahead, the Russell 2000’s performance will hinge on several factors.

• Trade policy developments: A lasting resolution to U.S.-China trade tensions could provide sustained support for small-cap stocks.

• Economic indicators: Continued economic growth and consumer spending will bolster small-cap companies.

• Interest rates: Stabilizing or declining interest rates could reduce borrowing costs, benefiting small businesses.

• Valuation and earnings growth: Small-cap earnings growth may outpace that of large caps in 2025, making them attractive to investors seeking growth opportunities.

The recent rally in the Russell 2000 underscores the sensitivity of small-cap stocks to macroeconomic developments, particularly trade policies. While the short-term outlook has improved due to the U.S.-China trade truce, investors should monitor ongoing negotiations and economic indicators closely.

Selective investment, focusing on fundamentally strong small-cap companies, may offer the best opportunities in the evolving 2025 landscape.