Tuesday’s cooler inflation print could mean it’s finally time to pivot into small caps and lower-quality stocks, according to Morgan Stanley. The Bureau of Labor Statistics reported that the consumer price index showed a year-over-year increase of 2.7% in July , less than a Dow Jones consensus for 2.8% expansion. The report soothed stagflation fears and added to hopes that the Federal Reserve could actually cut more times this year than previously anticipated. The central bank is now projected to make three quarter percentage point cuts this year, up from two, according to the CME FedWatch Tool . If that outlook holds, as more traders are starting to expect, that could be a boon for small caps and lower-quality stocks — which have skipped out on this year’s gains by the larger caps. “What if we don’t see material signs of inflation pressure in the July CPI report? Bond market pricing of a September cut (currently at a ~90% probability) could rise further,” Mike Wilson, chief U.S. equity strategist at Morgan Stanley, wrote Monday — the day before the CPI report. “This has the potential to catalyze a more durable rotation to small caps and lower quality stocks should it play out.” In fact, the strategist said, it could mean a change in leadership. The S & P 500 is up more than 8% year to date and near all-time highs, as investors pile into larger companies with fortress balance sheets to weather headlines out of Washington and a choppy macroeconomic outlook. But an improving monetary policy outlook could be a boon to small caps and lower quality companies — which are sensitive to changes in interest rates. Wilson said he’s bullish over the next six-to-12 months because of a rebounding earnings and cash flow environment. Plus, if both asset classes start to catch up, there would be a sizable gap to close. The small cap Russell 2000 has only eked out a meager gain in 2025. And, even the equal-weighted broad market index is up only a little over 4%. Some names of companies with weak balance sheets and low returns on capital include Caesars Entertainment , United Airlines , and Dollar General , according to a recent screen from Goldman Sachs. “We think it makes sense for equity investors to stay nimble around this week’s CPI report as a leadership shift under the surface of the market could take hold depending on the result,” Wilson added.
