Many stock strategists began the year harping for a rebound in small cap performance as consensus believed the Federal Reserve would begin reducing interest rates in the first half of 2024. Now, with the market scaling back its hopes for interest rate cuts this year, the small cap Russell 2000 Index (^RUT) is down nearly 3% year-to-date, underperforming compared to the S&P 500’s more than 5% gain this year.
“We think the Russell 2000 could be a bit challenged in the near term, until we get to kind of greater confirmation of inflation slowing and greater confirmation that okay, the Fed is going to be able to start cutting rates,” Bank of America head of US small & mid cap strategy Jill Carey Hall told Yahoo Finance.
After recent conversations with investors, Hall said the main catalyst for small caps to move higher is more clarity on the Federal Reserve’s interest rate path.
Market consensus has shifted from projecting seven rate cuts this year in early January, to two rate cuts this year, per Bloomberg data. The move has put a significant damper on the rally seen in small caps to close 2023, while large cap stocks have still clung to gains this year despite the shifting Fed narrative.
They key difference is the companies’ debt structure. Small caps have more than 40% of their debt exposed to higher rates either in the form of floating rate loans, which are exposed to current interest rates, or short-term debt that could need to be refinanced amid the higher rate enviornment. This compares to the roughly 75% of S&P 500’s which have long-rate fixed debt, per Bank of America’s research team.
Add in that large cap companies often have more cash that could benefit from higher rates, and the Fed not cutting rates is simply more costly for smaller companies than larger companies.
“The [Russell 2000] index is very sensitive to credit and rates,” Hall said. “Refinancing risk is a key risk for these companies given that large caps were able to lock in a lot of long dated fixed rate debt…the longer rates stay high, that becomes a bigger and bigger risk to earnings for these [smaller cap] companies.”