Small-caps well-placed despite caution on Fed cuts

Deep Dive video: How could investors prepare for a “Goldilocks” scenario? (7:07)
Watch CIO Head of Cross Asset Allocation Crystal Zhao discuss how investors can prepare for a potential Goldilocks scenario in the US economy.

Markets have continued to respond to strong US economic data and indications from top Federal Reserve officials that they are in no rush to cut rates. The yield on the 10-year US Treasury has risen by 28 basis points since Thursday's close, the biggest two-day increase since June 2022-a time when the Fed prepared markets for the first 75-basis-point hike since the 1990s.

The move followed comments from Chair Jerome Powell over the weekend that “the danger of moving too soon is that the job’s not quite done.” This caution was echoed by Minneapolis Fed President Neel Kashkari that the Fed had “time to assess upcoming economic data before starting to lower the federal funds rate.” Finally, a survey of service sector businesses from the ISM showed that purchasing managers are still seeing inflationary pressures, with the prices paid component of the survey rising to an 11-month high.

This combination has been a particular headwind for small-caps, which generally benefit most from Fed cuts due to their higher reliance on floating rate debt. The Russell 2000, a US small-cap index, fell 1.3% on Monday and is down 4.4% year to date. By comparison, the large-cap S&P 500 was off just 0.3% on Monday and is up 3.6% so far in 2024.

But we expect recent developments to be only a temporary setback for small-caps, which we expect to outperform in 2024.

The Fed is still on track to trim rates in 2024, helping small-caps more than larger peers. Although market hopes of a start to rate cuts at the Fed’s March meeting have faded, we don’t expect a long delay to the start of the easing cycle. The broad trend toward slowing inflation has continued, with the core personal consumption expenditures index-the Fed’s favorite gauge of prices-running at an annualized rate of 2% in the fourth quarter. Against this backdrop, our base case remains for the Fed to cut by 100 basis points this year. A “Goldilocks” scenario also remains possible, in which inflation falls faster than expected despite strong growth-allowing the Fed to cut by around 150 basis points instead. Since nearly half of the debt held by Russell 2000 companies is floating rate, versus around a tenth for large-cap companies, Fed rate cuts can quickly start to reduce interest expenses for small-cap companies.

The recent tightening on lending standards by banks also looks to be fading, a positive trend for more modestly sized companies. With less access to capital markets, small-caps rely more on credit from banks. Here too there is encouraging news. The release on Monday of the Fed’s latest Senior Loan Officer’s Survey, which tracks lending trends at banks, suggested that the recent trend toward stricter lending standards is abating. Credit standards for commercial and industrial loans tightened at the slowest pace in seven quarters in the last quarter of 2023.

While some banks could face problems due to exposure to struggling parts of the commercial real estate market, we don’t expect this be a major drag on lending to small companies-or to credit growth in general. The main problem in commercial real estate is in office properties, which account for less than 5% of total bank loans. Even for regional banks, which are more exposed to this area, commercial real estate accounts for about 5–10% of loans.\

The cyclical resilience of the US economy should help small-cap earnings more than the broader market. The Russell 2000 index has a higher exposure to sectors that are more sensitive to shifts in the economic cycle. Industrials are the largest single sector, with a weighting of close to 19%-compared to less than 9% in the S&P 500, where it is the fifth ranking industry. As a result, recent indications that the US economy has been stronger than expected-including strong employment gains in January and GDP growth in the fourth quarter-provide a positive backdrop for small-caps. Swings in profits tend to be larger for the Russell 2000 compared to the large cap index-both on the upside and downside. We expect small-cap earnings per share growth to exceed our forecasted rise of 8% for the S&P 500. In a Goldilocks scenario, in which growth remains at or above the long-term trend, small-caps would be even better positioned.

So, our view is that small-caps can overcome recent headwinds, and we expect them to outperform the broader market both in our base case for a soft landing, and even more so in the event of a “Goldilocks” scenario. A modest allocation to small-caps has the potential to improve returns and diversification in portfolios, though investors should be aware of various pitfalls-including an increased vulnerability to economic disappointments, lower liquidity, and generally weaker balance sheets.