Why should smaller companies get a boost? The Citi strategists argue that they will benefit from lower interest-expense costs, particularly since small and mid caps have more floating-rate debt than larger rivals.

Bigger companies have also been piling up sizable cash balances over the past few years, earning a healthy chunk of net interest income in the process. But Citi strategists said “we expect a reversal of much of the excess interest income companies were earning on cash balances in the last few years” now that inflation seems to be cooling and the Fed could be getting ready to finally cut at some point this fall.

The higher-for-longer rates environment that has clearly been a negative for smaller companies should be soon coming to an end. Traders see more than a 63% chance for a rate cut in September, and nearly 90% odds for a cut in December…after the presidential and congressional elections.

“Small and mid-caps have already priced in much of the impact of higher interest rates, and we think they should perform well provided rates continue to stabilize,” Mimi Duff, managing director with GenTrust, wrote in an email to Barron’s.

All told, Citi estimates that rate cuts could lead to a nearly 2% reduction in earnings for the S&P 500

SPX

0.25%

(excluding financials) over the next 12 months but a slight increase to profits for the mid-cap S&P 400

MID

-0.17%

and small-cap S&P 600 indexes (also excluding financials.)

“At work is the trade-off between interest income on cash relative to interest expense on floating- and fixed-rate debt,” the Citi strategists said.

That earnings lift could be crucial given the valuation gap between small and large stocks. In fact, other experts argue that the fact that small-caps trade at such a big discount to the S&P 500 bodes well for indexes like the Russell 2000

RUT

-0.20%

and S&P 600, too.

Equity and quant strategists at BofA Securities noted in a report Thursday that the Russell 2000 now trades for just 14.5 times forward earnings estimates, below its historical average. The strategists noted that the bigger than usual discount to larger caps “argues for small cap outperformance over the next decade.”

The BofA strategists also believe that “cyclical sectors continue to rank better than defensive sectors” as the outlook for rate cuts and the broader economy improves. They are expecting a manufacturing recovery, and as such, think that industrials and energy are top small-cap sectors.

The BofA strategists added that those two sectors have seen the biggest increase to sentiment and trade at low valuations. In a report last month, the BofA strategists highlighted industrials Titan International, Hub Group, and Moog, power-conversion company Advanced Energy Industries, and utility Otter Tail as top small-caps.

Midsize companies might also be in a sweet spot as rates edge lower, said Neil Hennessy, chief market strategist with Hennessy Funds. He told Barron’s that many investors, flush with cash, will be looking to invest beyond the Magnificent Seven stocks that have helped lift the S&P 500 (and the Dow to some extent) higher.

“There are tons of money sitting on the sidelines. It’s going to go into smaller value stocks as interest rates are going to start to edge down,” Hennessy said.

The firm’s Hennessy Cornerstone Mid Cap 30 Fund owns companies that Hennessy said should benefit from a stable economy and are both large enough to potentially make smart, accretive acquisitions of tinier rivals but also are small enough to be tempting takeover targets for large caps.

The fund’s managers uses a quantitative strategy to pick stocks, but that has recently pushed the fund into many consumer-oriented companies, precisely the types of firms that stand to gain the most from lower interest rates and diminishing inflation pressures. Retailers Gap, Abercrombie & Fitch, Sprouts Farmers Market, and Guess? were all top 10 holdings as of the end of the first quarter.

Write to Paul R. La Monica at paul.lamonica@barrons.com