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Small and midsize US stocks are struggling under the strain of high interest rates, as the Federal Reserve’s commitment to maintaining higher borrowing costs for an extended period jeopardizes the financial stability of smaller companies.
The Russell 2000 small-cap index has plummeted 11% since reaching its peak in July, while the S&P 500 has declined 7% during the same timeframe. This September alone, the small-cap index has dropped 7%, leaving it more than 27 percentage points below its all-time high in 2021, in comparison to 11 percentage points for the S&P.
This underperformance underscores how smaller stocks are particularly vulnerable to the effects of the Fed’s interest rate hikes, just as some market observers raise doubts about the effectiveness of interest rate transmissions to the economy.
Analysts attribute the decline in small caps to the sharply rising interest costs faced by smaller companies. Interest expenses for the S&P 600, another small-cap index, hit a record high in the latest batch of second-quarter earnings, as per data compiled by Ned Davis Research.
“This is new, uncharted territory for small caps,” said Ed Clissold, the US strategist at Ned Davis, suggesting that smaller companies now face the possibility of enduring persistently high rates or entering a recession.
Compared to their large-cap counterparts, small caps generally have weaker balance sheets. They have higher levels of debt relative to their profits, and interest payments consume a larger portion of their earnings.
A crucial factor behind the decline of small caps is the proportion of floating-rate debt held by Russell 2000 companies, which exposes them to a rising interest rate environment. In contrast, only 6% of the S&P 500’s debt stock is floating-rate, according to Goldman Sachs.
Dec Mullarkey, managing director at investment firm SLC Management, stated, “Because of this floating-rate debt, rising rates will pinch and defaults are likely to rise.”
“More small companies tend to rely on bank lending, which has grown very restrictive,” he added. “Smaller companies tend to have more competition and less pricing power, which pressures margins as inflation stays high and wages increase. And, as growth slows, that will also amplify the margin squeeze.”
Compared to the S&P 500, broad small-cap indices are comprised of a larger number of regional banks and industrial companies. These sectors tend to suffer as investors lower their expectations for economic growth, as has been observed recently, according to Ryan Hammond of Goldman Sachs’s US equity strategy team.
The Russell 2000 also includes a greater number of life sciences firms compared to large-cap indices. Given that the vast majority of these firms aren’t profitable, their performance is highly sensitive to growth and interest rates.
While larger companies have also experienced higher funding costs, the increase has been less significant. This is partly due to bigger firms having lower capital costs and many companies extending their debt maturities after the onset of the coronavirus pandemic and central banks reducing borrowing costs.
The impact of increased interest expenses on larger companies has been offset by their larger cash reserves, which generate more interest income in a higher rate environment.
Among the major beneficiaries of rising interest income are the dominant US large-cap tech companies. S&P Capital IQ data reveals that in the 12 months leading up to June, these “magnificent seven” tech firms earned $13.3 billion in interest income while paying out only $9.6 billion in interest expenses. Alphabet, for instance, has seen its quarterly interest income more than double since the Fed began raising rates early last year, while its quarterly interest expenses have decreased.
However, the lower valuations of small caps could potentially attract buyers in the future. According to Goldman’s Hammond, the two most critical factors for Russell 2000 returns are economic growth and starting valuations. Should the economy experience a soft landing, as Goldman predicts, the conditions could be favorable for small caps to perform well.
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