Small U.S. companies, which underperformed the broader market this year, face a cloudy outlook due to the Federal Reserve’s continued focus on fighting inflation through high interest rates.
Earlier expectations of the Fed easing monetary policy had fueled a surge in small cap stocks at the end of 2023. However, persistent inflation has dashed hopes of imminent rate cuts, hindering small cap performance. The Russell 2000 index, a benchmark for small caps, has only gained 0.4% year-to-date compared to the S&P 500’s 7.5% increase.
Investor skepticism prevails due to higher rates and inflation. They await a clearer signal from the Fed about potential rate cuts before shifting investments towards small caps.
Recent signs, however, offer a glimmer of hope. Slower-than-expected job growth in the latest employment data eased concerns about prolonged high rates, leading to a 1% gain for the Russell 2000. Additionally, Fed Chair Powell reiterated his belief in lower rates later this year despite inflation.
Futures markets now anticipate around 45 basis points of rate cuts this year, up from earlier estimates of less than 30. However, this remains significantly lower than the 150 points anticipated in January.
While stronger-than-expected earnings in the coming weeks could boost investor confidence, the overall outlook for small caps remains uncertain. The Russell 2000 is expected to experience an 8.4% earnings decline compared to the S&P 500’s projected 10.2% growth. Moreover, small caps trade at a higher valuation (22 times earnings) compared to the S&P 500 (20 times earnings).
“The earnings pickup we expected hasn’t materialized,” says David Lefkowitz of UBS Global Wealth Management, who remains overweight on small caps. He acknowledges the rationale behind favoring small caps but emphasizes the dependence on the interest rate outlook.
Several notable small cap companies will report earnings this week, including Bellring Brands, Light & Wonder, and Permian Resources. Meanwhile, the larger cap earnings season continues with reports from Walt Disney, Wynn Resorts, and Akamai Technologies.
Despite recent positive developments, the path to rate cuts remains ambiguous. Experts advise investors considering small caps to focus on companies with strong fixed debt positions and low leverage, as they are better equipped to handle an extended Fed pause on rate cuts.