US Small-Cap… Lower Rates to the Rescue?

SUMMARY

• Higher short rates have dragged down small-cap… but rate policy is becoming more favorable.
• We believe some sectors will recover faster than others – earnings will be the key.
• Our team is cautiously weighing small-caps against other value-oriented investments.

In 2024, we wrote a Strategic View outlining some of the structural headwinds that high interest rates created for US small-cap stocks, and concluded they were likely to face challenges, despite their seemingly attractive valuation – a classic ‘value trap’. As we contemplate the Federal Reserve imminently lowering interest rates, we wanted to provide an update on this topic. Below we explain why a rate cut cycle may be a potential tailwind for small-cap earnings and returns. We also provide some guidance for selection within the asset class.

Economic Resiliency Matters for the Stock Market

Since the Great Financial Crisis of 2008, the dominant economic backdrop has been one of low economic growth and low interest rates. We believe this type of environment is ideal for growth-oriented companies and market segments like US large-cap. This is because large-cap indices tend to be stocked with companies that are scaled enough to generate large profits off small amounts of economic growth. This, along with the strength of software-as-a-service, cloud computing and artificial intelligence (AI) are the primary drivers of large-cap dominance over the decade and a half. Most of the other major equity asset classes we follow – such as US small-cap and international - tend to have more “value-oriented” companies.

Value-oriented companies tend to struggle in lower economic growth environments due to larger fixed costs and lower profit margins. The upside of these types of businesses is they tend to grow earnings faster in an environment of elevated economic growth, moderate inflation, and a steep yield curve. Due to the COVID-driven inflation spike in 2021, we abruptly jumped to an environment of high interest rates. This is a backdrop which is hostile to all equity markets, but especially to small-caps, in our view.

Fortunately, inflation has slowly come back under control, and it appears the path is now set for the Federal Reserve to lower short interest rates. We would expect a “value rotation” if this rate increase can occur without re-igniting inflation, or if a recession does not start.

Our Price Matters® framework (Chart 1, above) suggests small-caps have a faster long-term historical return trend (8.2% per annum, versus 6.4% for large-caps) and currently are trading at -23.4% below that trend vs +37% above trend for Large Caps. This suggests to us that, looking out over the next decade, small-caps are likely to have a higher total return than large-caps. However, we believe that value is a ‘condition’ and not necessarily a ‘catalyst’ for better returns, if not supported by growing corporate earnings. The high interest environment we have weathered since 2022 has proved particularly challenging for small cap earnings. We believe it will improve, however, if interest rates continue to decline.

Why US Small-Caps Are Impacted More by Higher Short-Term Interest Rates

While higher rates impact all indebted companies to some degree, higher interest rates tend to affect small-cap companies more acutely than large-cap companies. Comparing small-cap companies to their large-cap counterparts, we observe three general tendencies:

1. Small-caps tend to use more debt than large-caps: Small-caps tend to have higher debt as a percentage of assets and lower coverage of debt payments as a multiple of their earnings. This means they may be more susceptible to credit issues.
2. Small-caps tend to borrow at higher rates: The average credit quality of large cap companies in the S&P 500 is BBB+, which is considered ‘investment grade’. However, the average credit rating for all companies in the US is BB, a lower-quality rating that is ‘speculative grade’ or high-yield. This suggests that small-caps are typically forced to borrow at higher rates than large, due to small-caps’ higher perceived risk.
3. Small-caps tend to borrow for shorter periods than large-caps: High yield bonds tend to have shorter maturities, and a larger proportion of debt for smaller companies in floating rate loan products. This means that small-caps are more susceptible to rising rates and refinancing risk.

An additional wrinkle has been the shock that the rapid increase in interest rates caused the small-cap banking system to seize up abruptly in early 2023. Faced with a backdrop of higher rates, small-cap banks face challenges due to many of their listed assets being “underwater” – whether they are treasury bonds or commercial real estate. This provides both a direct headwind for small-cap banks, and an indirect headwind for all smaller companies that rely on these banks to fuel growth – they are restricting lending when it is needed the most.

While we believe rates are unlikely to fall back to 2020 levels, we do believe that lower interest rates can relieve some of those underwater assets. This will help some companies directly, and it unlocks parts of the balance sheet of smaller banks for lending. While it would be premature to give any kind of “all clear” for investors in small-cap banks, we can now see a possible path forward for small-cap companies to begin unlocking some of their earnings potential. We can see some areas where this is occurring through looking at earnings of small-cap companies.

Bottom-Up View: Small-Cap Earnings are Slowly Improving

Solely focusing on valuations while ignoring earnings and macro catalysts can lead to owning “value traps” with disappointing returns. When we see a macro thesis being borne out in the positive earnings growth of companies, we see that as a powerful signal. While the Federal Reserve is now likely to further lower interest rates in the quarters ahead, here are some themes we wanted to highlight where earnings are already improving. This is a slightly deeper dive into what we explored a few weeks ago in our Q2 earnings recap.

1. Earnings and revenue have been better than analysts expected: One of the encouraging signs from our analysis of earnings is that revenue and earnings came in better than analysts expected in the second quarter across the vast majority of the sectors and in the market as a whole. Given the concerns about tariffs impacting small-cap revenues and earnings, this is a very encouraging result.
2. Growth is positive overall but inconsistent across sectors: While earnings growth is positive when looking at the broad small-cap market, results appear more mixed on a sector level. Within the traditional cyclical sectors, Energy, Discretionary and Materials seem to be struggling, while Industrials and Financials are growing, as are Technology and Health Care companies. Defensive and interest rate-sensitive companies in Utilities, Communication Services and Real Estate are still underachieving, while Consumer Staples are performing well.
3. All of these readings are better than previous quarters: When comparing our results vs. previous quarters, we see consistent improvement. This is critical because it is consistent with our thesis that lower rates and moderating inflation are having a positive impact.

Our takeaway is that the rate cuts in 2024 and the strong economic environment since 2023 has already improved the standing of some small-cap. We will be watching in quarters ahead for further improvement. We also realize that US small-cap, like any other asset class, is made up of lots of different companies and investment themes. We believe that there is a tremendous opportunity to engage in sector and stock selection within US small-cap depending on if an investor wants to seek deeper value or seek some themes that have already turned positive – we think Technology, Industrials and Health Care are all standout sectors to explore deeper.

Conclusion: Tide May be Turning for Small-Cap; We Will Consider Opportunities as Rate Path Becomes Clearer

Our analysis shows potential of a tailwind for US small-cap as Federal Reserve policy becomes more dovish, and some early green shoots in small-cap earnings. While this might seem like a clarion signal to begin adding exposure, there are a few things that give us pause. The first issue is risk and income considerations for our portfolios. Small-caps tend to have higher volatility, and lower dividend yields than their large-cap brethren. Both of these features make them less attractive for a more conservative portfolio allocation, or for investors with income needs. While sector selection and active strategies can mitigate some of that risk, we do tend to view small-caps as being an investment for highly risk-tolerant investors.

The second factor that is giving us pause is the opportunity cost versus other similarly value-oriented equity assets. US large-cap cyclicals are structured to benefit from steep yield curve and elevated economic growth, but are not as dependent on short-term financing. This could make them a safer investment if inflation rears it’s head and the rate cutting cycle stalls out. Similarly, international equities have cheap valuations, and likely benefit from the same macro backdrop as US small-cap. We also likely see the cut in short rates leading to headwinds for the dollar, which would benefit international equities simply from a currency translation effect.

In conclusion, while US small-cap is an option for us to invest in, we will have to weigh its’ risk-reward against other opportunities… even if our preferred economic scenario of lower rates and continued growth comes to pass. We also have to consider the possibility of increased inflation – this could reverse the current trend of lower rates.

Risk Discussion: All investments in securities, including the strategies discussed above, include a risk of loss of principal (invested amount) and any profits that have not been realized. Markets fluctuate substantially over time, and have experienced increased volatility in recent years due to global and domestic economic events. Performance of any investment is not guaranteed. In a rising interest rate environment, the value of fixed-income securities generally declines. Diversification does not guarantee a profit or protect against a loss. Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability. Please see the end of this publication for more disclosures.