Wells Fargo Investment Institute Tuesday downgraded U.S. small-cap equities to "unfavorable" from "neutral," pointing to its heavy tariff exposure, elevated interest rates and weak earnings record.

The broader U.S. equity market has rebounded on easing trading tensions and strong corporate earnings since hitting its lows in April following Trump's "Liberation Day" tariffs.

However, the small-cap Russell 2000 index has not had the same pace of recovery, having fallen 0.9% this year, including session movements, whereas the large-cap S&P 500 index has gained 7%.

"Interest rates above their levels during past economic cycles should leave this group vulnerable," said strategists at Wells Fargo, adding that small caps are more exposed to tariff frictions as they have less flexible supply chains and thinner margins than their larger competitors.

Among the 545 companies in the index that have reported quarterly earnings so far, about 25% have missed analysts' expectations, compared to about 15% in the large-cap segment, as per LSEG I/B/E/S estimates.

"A poor earnings track record and an elevated portion of index components with no profits have continued to plague...the Russell 2000 index," Wells Fargo added.

The investment institute, a subsidiary of Wells Fargo bank , also downgraded its stance on the U.S. energy and communication services sector and the broader commodities asset class to "neutral" from "favorable."

While Wells Fargo foresees a turbulent second half of 2025 amid tariff-related headwinds, it remains optimistic about the economy's trajectory, expecting momentum to strengthen in 2026, with trade uncertainties unlikely to pose a major threat.