Market perspectives

Vanguard’s outlook for financial markets

Our 10-year annualized nominal return and volatility forecasts are based on the June 30, 2025, running of the Vanguard Capital Markets Model®.

What happened to the small-cap premium?

U.S. small-caps have significantly underperformed their large-cap counterparts over the last decade. This is a reversal from what investors have come to expect since the 1990s, when academic research argued for the existence of a “small-cap premium.”¹ Although non-U.S. stocks—which have also lagged over the last decade—have enjoyed a resurgence in 2025, small-caps have continued to struggle despite their attractive valuations. Tariff concerns are at least partly to blame, as small-caps have historically been more cyclical and economically sensitive.

Our research, however, suggests that more structural factors may be at play. Smaller companies have deteriorated in quality compared with large-caps. Through July, almost a third of the companies in the Russell 2000 Index were loss-making based on annual earnings per share. Much of large-caps’ vaunted valuation premium appears at least partly justified by their superior profitability.

The initial public offering (IPO) market also appears to have played a part in small-caps’ underperformance. Although hundreds of young, promising small-cap companies have gone public in the past, many are now staying private for longer and going public at large-cap levels, if at all. This has led to the composition of the public small-cap universe becoming older over time. Additionally, the companies that have gone public over the last 10 years have tended to be less profitable than in prior decades.

Structural disadvantages and sector gaps are weighing on small-caps

The historic outperformance of mega-cap technology stocks, often referred to as the “Magnificent Seven,” has played a role in the divergence between large- and small-caps. These stocks (Nvidia, Microsoft, Apple, Alphabet, Amazon, Meta Platforms, and Tesla) have accounted for half of large-caps’ annualized outperformance of around 6 percentage points over the last 10 years. Differences in sector composition between large- and small-caps have also been a driver—tech stocks comprise 37% of the Russell 1000 but just 12% of the Russell 2000.

The increase in interest rates over the last few years has weighed disproportionately on small-caps. While larger-cap companies were able to lock in low rates on very long-term debt when rates were lower, many small-cap companies with short-term debt structures have had to roll over their debt at higher interest rate levels. This has led to an increase in the percentage of small-caps with an interest coverage ratio (operating income divided by interest expense) of less than 2, a level generally considered safe as it means a company is earning at least twice what it needs to cover its interest payments.

Against this challenging backdrop, active small-cap fund managers have fared much better than their large-cap counterparts.² Actively managed small-cap funds tend to have a quality bias, with underweights to loss-making companies, which has been a consistent tailwind for them.

Where to from here?

The decline in small-cap valuations has been warranted, arguably, by their decline in quality. The question now is whether the repricing has gone too far, with expectations for small-caps too bearish and those for large-caps too lofty. Looking at the price-to-earnings data another way, even when limiting the universe to “quality” companies (those with returns on invested capital of more than 20%), small-cap stocks appear very cheap compared with large-caps of comparable profitability.

Our capital markets forecasts suggest that valuation differences have indeed grown too wide. We expect small-caps to outpace large-caps by an annualized 1.9 percentage points over the next decade. However, some caution is warranted given the prevalence of small-cap companies with weak profitability and risky balance sheets. Investors may want to consider low-cost active funds where skilled managers can be selective or funds employing factor-based strategies emphasizing quality and valuation.

United States: On track, but treading carefully

Recent trade developments have helped reduce some uncertainty for the U.S. economy, leading us to raise our baseline assumption for the effective tariff rate modestly higher to a range near 17% by year-end. However, the economic impact of offsetting factors such as foreign investment agreements and the delayed pass-through of elevated tariff rates to consumers will need to be evaluated as more information emerges. For now, we see the economy tracking in line with our expectations of a softening labor market, GDP growth of around 1.5%, and core inflation of around 3% by year-end.

The coming months will be pivotal in assessing how well the economy is able to absorb tariff-related pressures, which will then play a leading role in determining monetary policy. For the first time in this cycle, revisions to the July labor market report showed an economy that added fewer jobs than what we estimate to be the replacement rate (around 75K), a sign that the economy is oscillating around a neutral growth rate.

Prior to the labor market report, we viewed communication from the July Federal Reserve meeting to be mildly hawkish toward a September rate cut, a stance we expect will now shift toward a renewed focus on the employment side of the Fed’s dual mandate. We see the Fed as on track for two rate cuts this year, given recent softness in the labor market and with monetary policy still a percentage point above our estimate of a neutral stance. 

Region-by-region outlook

Notes: Values are approximate. GDP growth is defined as the annual change in real (inflation-adjusted) GDP in the forecast year compared with the previous year. Unemployment rate is as of December 2025. Core inflation is the year-over-year change in the Consumer Price Index, excluding volatile food and energy prices, as of December 2025. For Canada, monetary policy is the BoC’s year-end target for the overnight rate. For the United Kingdom, monetary policy is the Bank of England’s bank rate at year-end. For the Euro area, monetary policy is the European Central Bank’s deposit facility rate at year-end. For China, monetary policy is the People’s Bank of China’s seven-day reverse repo rate at year-end. For Japan, monetary policy is the BoJ’s year-end target for the overnight rate. For the United States, monetary policy is the upper end of the Federal Reserve’s target range for the federal funds rate at year-end.

Source: Vanguard.