By Lisa Pauline Mattackal

(Reuters) – U.S. small-cap stocks have surged to near record highs following Donald Trump's presidential election win, but some investors are wary of chasing the rally due to fears that his policies could drive a resurgence in inflation, hurting the rate-sensitive sector.

The Russell 2000 index has jumped around 6% since the election on Nov. 5, outperforming gains in major indexes due to expectations that Trump's proposals to cut taxes, decrease regulations, and increase tariffs would boost domestically focused small caps.

However, some analysts and portfolio managers believe these policies could increase the cost of goods and stoke inflation, potentially derailing the sector's performance, especially if renewed inflationary pressure leads to fewer-than-expected Federal Reserve interest rate cuts.

Investors have already dialed back expectations for rate cuts in 2025, pushing Treasury yields to multi-month highs.

"We think (inflation) is probably the biggest under-appreciated risk by markets," said Sameer Samana, senior global market strategist at Wells Fargo (NYSE:WFC) Investment Institute (WFII), who maintains a neutral rating on small caps.

"Right now, large caps seem higher quality (and have) better earnings growth; it's just very difficult to drop down to smalls when they don't have much going for them right now."

Small-cap companies tend to carry more debt on their balance sheets, meaning an increase in interest rates could raise borrowing costs and make servicing their debt more challenging, analysts say.

Jamie Battmer, chief investment officer at Creative Planning, cautioned that Trump's tariffs would force small caps to navigate a "delicate balancing act."

The Russell 2000 has gained about 19% in 2024 but lags behind the benchmark S&P 500's 26% rise and the Nasdaq's 28% gain.

Despite the index's underperformance this year, valuations are high. The Russell 2000 is trading at around 28.3 times forward earnings, according to data from LSEG, compared to the S&P 500's 22.7.

"What we are focusing on is earnings and quality – and small caps don't really fit that," said Jim Caron, chief investment officer, cross-asset solutions at Morgan Stanley (NYSE:MS) Investment Management.

Ryan Dykmans, chief investment officer at Dunham & Associates Investment Counsel, noted that while his firm has been adding to small-cap holdings, it has focused on companies with less debt.

"If rates are going to stay as high as they are today for another year, you're going to see a lot of small-cap companies just burn out," said Dykmans, suggesting difficulties in paying down interest on their debt or obtaining new loans.

Investors seeking to add small caps are better off waiting for dips instead of buying at current levels, advised WFII's Samana.

(This story has been corrected to say the Russell 2000 index 'jumped around 6% since the election', not 'nearly 31%,' in paragraph 2).