Fed rate cuts were supposed to support small-cap stocks. What's holding them back?

By Isabel Wang

Small-cap stocks were expected to benefit the most from the Federal Reserve’s interest rate cuts, but this has not yet happened.

A brief rally faded quickly after the US central bank last month cut interest rates for the first time in four years. Rising Treasury yields BX:TMUBMUSD10Y and uncertainty about the upcoming election have put pressure on companies, especially in one of the most speculative corners of the stock market.

This week, a significant decline in small-cap markets caused the Russell 2000 RUT, which consists of the 2,000 small- and mid-cap companies in the Russell 3000 RUA, to have its worst week since early September. The index fell nearly 3%, following a 1% weekly decline in the broad S&P 500 SPX and a 0.2% gain in the Nasdaq Composite COMP, according to FactSet data.

This month, small-cap stocks have given back most of the gains from last month’s post-cut rally and are down 1% so far in October; The S&P 500 rose 0.8% and the Nasdaq rose 1.8%. during the same period, according to FactSet data.

Small companies are generally more sensitive to changes in interest rates and economic conditions than larger companies because they have more debt and are more reliant on external financing to finance their operations than larger companies.

This year, stock market investors spent much of the first eight months of 2024 worried that the US economy could cool rapidly, so they expected multiple rate cuts by the end of the year. But a string of strong economic data from the past month has led some to wonder whether the central bank made the right decision with its massive 50 basis point rate cut in September and could risk a resurgence in inflation.

“We’ve moved from a truly dire July jobs report to much more constructive economic data, suggesting the Fed will not be as accommodating as previously priced in,” Chief Investment Officer Shannon Saccocia said. Neuberger Berman Private Asset.

He said the current macro market environment after the Fed’s first rate cut has become “a little bit less attractive” for small caps, at least in the short term.

See: Do investors suddenly care whether Trump or Harris wins? What awaits stocks in the last days before November 5?

The interest rate uncertainty comes at a time when financial markets are suddenly nervous about whether Donald Trump or Kamala Harris will win the White House. With just 10 days until Nov. 5, election excitement is finally beginning to affect stock and Treasury markets amid concerns that a new presidential administration could worsen the U.S. government’s fiscal deficit.

The stock market is “definitely not in a risky” environment right now, Saccocia told MarketWatch by phone on Friday. “Small businesses in particular are hesitant to advance growth initiatives for next year until we have a better understanding of policy in Washington,” he said.

See: Election bets are influencing some stock market investors as Trump’s chances rise

Investors ‘hiding’ in megacap stocks in times of uncertainty

Another challenge for small companies in the recovery is that small companies may not be able to generate the same level of earnings growth compared to their larger peers, and so they must rely on aggressive interest rate cuts to provide a “stimulus boost” to their valuations, Saccocia said. in question.

He noted that this “will allow small-cap investors to be more comfortable with the fact that small-cap investors may not be able to deliver the same level of earnings growth today or in the first half of 2025, but they will get that impetus from rate cuts.” .

Of course, valuations appear to favor small caps. According to FactSet data, as of October 25, the forward 12-month price/earnings ratio of the S&P SmallCap 600 index SML was 14.9, while the S&P 500’s was 21.2.

But for now, Saccocia added, investors may want to “hang on” to large-cap companies with “strong balance sheets and meaningful free cash flow” in times of uncertainty.

Jordan Irving, small-cap portfolio manager at Glenende Investment Management, suggested that investors should not “predict” every economic data as a new direction for where the economy is heading, as it could easily send “wrong signals”.

“What we need to see next for small caps to outperform longer term is the consolation that the economy is not going into a catastrophic recession, but also that the economy is not hot enough to cause a crisis. The Fed will reverse course,” Irving told MarketWatch by phone on Friday. in his meeting.

U.S. stocks ended Friday mostly lower to cap a volatile week. The Dow Jones Industrial Average DJIA fell nearly 260 points, or 0.6%, while the S&P 500 was nearly flat and the Nasdaq rose 0.6%, according to FactSet data.

-Isabel Wang

This content is from Dow Jones & Co. Created by MarketWatch, operated by . MarketWatch is published independently of Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones News Wire

10-26-24 0630ET

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