Small-cap stocks have been underwater since the beginning of June—and declining interest rates might be the culprit.
While the large-cap Russell 1000 index (.RUI) has bounced back almost 8% since June on hopes of further rate cuts from the Federal Reserve, the small-cap Russell 2000 index (.RUT) has gained only 3%.
Investors might still remember small-caps’ stellar run in early 2018, when trade-war fears drove more assets into the group, which is typically less exposed to international markets. That thinking has changed, with investors realizing that in today’s globalized economy, no asset class is safe in a full-blown trade war.
Something else is driving small-caps’ underperformance, according to Alec Young, FTSE Russell’s managing director of global markets research—exposure to lagging sectors. “While many factors impact size performance, sector exposures tell a big part of the story,” Young told Barron’s. “Smart money now has shifted from focusing on geographical sales exposure to sector differentiation, specifically on technology and financials.”
As of mid-August, the Russell 2000 index sported a hefty 27% weighting in financial stocks, well above the 21% for the Russell 1000, for example. As financial stocks have struggled, the small-cap index has felt a bigger drag.
Lower interest rates are generally positive for the economy. They encourage consumers and companies to borrow more money, which boosts business activity and helps give the current cycle a longer runway. But lower rates are bad news for banks, whose profit margins depends in part on the interest income from issued loans.
Since banks borrow short-term and lend long-term, the spread between short-term and long-term rates—the so-called yield curve—is especially important to their profitability. But the yield curve has been flattening as bond investors get more pessimistic about the future, with the spread between 10-year and two-year Treasuries recently inverting.
Even worse, since smaller banks usually don’t have a diversified revenue stream—such as investment banking, mergers and acquisitions, and initial public offerings—like bigger banks do, they tend to be more dependent on lending and therefore even more sensitive to interest rates. Earnings of Russell 1000 stocks are up 2% compared with a year ago, but they declined 5% for the small-cap Russell 2000, according to Young. The pressure on the financial sector is one of the main drags, he explains.
Since June, financial stocks in the S&P 500 (.SPX) increased by 5.5%—already much lower than most of the sectors in the index—but those in the S&P SmallCap 600 index (.SML) performed even worse, with gains of only 1.9%.
But fears over banks’ profitability might have been overdone, as many of them are in a much healthier financial state compared with 10 years ago, during the financial crisis.
“Although ultra loose monetary policy may hinder bank revenues, their earnings outlook is generally more sanguine,” Causeway Capital Management wrote in a recent blog post. “Most banks have used this past decade to streamline operations and boost their earnings and capital ratios. Controlling what they can, competent bank management teams have cut costs feverishly and repaired balance sheets.”
Stocks in the Invesco S&P SmallCap Financials exchange-traded fund (PSCF) are trading at only 12 times forward earnings, much lower than their five-year average and the valuation level of the broader S&P SmallCap 600 index, according to FactSet.
To see a small-cap comeback, interest rate will likely need to bottom out and the yield curve will need to widen again, says Young. A trade deal between the U.S. and China could be a catalyst for that to happen. “All this means that it may be time to re-evaluate small-cap allocations,” says Young.
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