The prospect of interest rates remaining high as the Federal Reserve battles inflation further clouds the outlook for U.S. small business stocks, which have lagged broader markets this year.
Small-cap stocks surged in late 2023 amid expectations that the Federal Reserve would finish raising interest rates and soon begin easing monetary policy. This would be a welcome change for small businesses, which rely more heavily on debt financing and consumer spending.
But continued high inflation has eroded prospects for rate cuts this year, and small-cap stocks have suffered. The Russell 2000 is up just 0.4% since the start of the year, far less than the S&P 500, which has gained 7.5%. Earnings are also expected to be weak, providing little incentive for investors to shift away from larger companies to other, less risky parts of their portfolios.
“Investors are currently skeptical of small-cap stocks due to rising rates and inflation, and they need greater clarity that the Fed will cut rates this year before to step in,” said Michael Arone, chief investment strategist for State Streets SPDR Business, who has been buying small-cap stocks in anticipation of a rate cut later in the year.
The case for small caps may have improved over the past few days. U.S. jobs data showed Friday that job growth, while remaining relatively robust, slowed last month, easing concerns that rates will remain high for the rest of the year. of the year. The Russell 2000 index rose about 1% on the day.
On Wednesday, Fed Chairman Jerome Powell said he still thinks rates will fall this year, despite stubborn inflation.
Futures markets on Friday showed that investors expected about 45 basis points of interest rate cuts this year, up from less than 30 basis points at the start of the week. This figure remains well below the 150 basis points forecast in January.
Stronger-than-expected earnings in the coming weeks could help ease investor concerns. Overall, the Russell 2000 is expected to post earnings growth of -8.4% in the latest quarter, compared to a 10.2% earnings growth rate for the S&P 500, according to LSEG data. At the same time, the Russell 2000 trades at a forward price-to-earnings ratio of 22, compared to a multiple of 20 for the S&P 500, making small caps more expensive.
“The earnings recovery that we expected just hasn’t happened,” said David Lefkowitz, CIO head of US Equities at UBS Global Wealth Management, which has been overweight small-caps since December. “I still think the small-cap bias makes sense, but it depends on your view on rates.
Small-cap companies reporting earnings in the coming week include nutrition company Bellring Brands, gaming company Light & Wonder and oil and natural gas company Permian Resources.
Large caps include Walt Disney, Wynn Resorts and Akamai Technologies as the US corporate earnings season continues.
Despite the encouraging developments of recent days, few believe that the path to lower interest rates is clear.
Jill Carey Hall, equity and quant strategist at Bofa Global Research, said investors buying small caps should focus on companies positioned to withstand an extended Fed pause, including those with higher percentages of fixed tooth and comparatively low leverage.
“It’s too early to predict further rate cuts,” said Timothy Chubb, chief investment officer at Girard. “A number doesn’t make a trend. Overall, the Fed is getting the evidence it needs.
