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Interest rate challenges for US small and mid-sized stocks

PUBLISHED

2023-09-29

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Small and mid-sized US stocks are grappling with the challenges posed by soaring interest rates, as the Federal Reserve's commitment to maintaining higher borrowing costs for an extended period threatens the fragile balance sheets of smaller enterprises.

The Russell 2000 small-cap index has experienced an 11 percent decline since reaching its peak in July, while the S&P 500 has seen a 7 percent drop over the same period. September alone has witnessed a 7 percent dip in the small-cap index, leaving it more than 27 percentage points below its all-time high in 2021, in stark contrast to the S&P's 11 percentage point retreat.

This underperformance underscores the acute impact of the Fed's interest rate hikes on smaller stocks, just as some market observers question whether interest rates' transmission to the broader economy has been hindered.

Analysts attribute a major factor behind the decline in small-cap stocks to rapidly rising interest costs for smaller firms. Data compiled by Ned Davis Research reveals that interest expenses for the S&P 600, another small-cap index, have reached record highs in the latest batch of second-quarter earnings reports.

Ed Clissold, US strategist at Ned Davis, commented, "This is new, uncharted territory for small caps," highlighting that smaller firms now face the prospect of either enduring high interest rates or navigating an economic recession.

Small caps generally exhibit weaker balance sheets compared to their larger counterparts, with higher debt-to-profit ratios and a greater share of earnings allocated to interest payments. Notably, 30 percent of the debt held by Russell 2000 companies is floating-rate, leaving them exposed to a rising rate environment. In contrast, only 6 percent of the S&P 500's debt carries such risk, according to Goldman Sachs.

Dec Mullarkey, Managing Director at investment firm SLC Management, warns that "rising rates will pinch and defaults are likely to rise" due to this floating-rate debt. He added that smaller companies often rely more on bank lending, which has become increasingly restrictive, and they face greater competition and less pricing power, which puts pressure on margins as inflation remains high and wages increase. As economic growth slows, the margin squeeze is expected to intensify.

Broad small-cap indices, such as the Russell 2000, also contain a higher concentration of regional banks and industrials, which tend to suffer when expectations for economic growth diminish. Additionally, the presence of more life sciences companies in these indices, the majority of which are unprofitable, amplifies their sensitivity to economic growth and interest rates.

While larger companies have also felt the impact of higher funding costs, the effect has been less pronounced. This is partially due to larger firms' lower cost of capital and their ability to extend debt maturities during the early stages of the COVID-19 pandemic when central banks slashed borrowing costs.

Furthermore, larger companies have been able to offset increased interest expenses with their substantial cash reserves, which generate more interest income in a higher rate environment. Notably, tech giants, which dominate US large-cap stock indices, have reaped the benefits. In the 12 months leading up to June, the top tech companies earned $13.3 billion in interest income while paying out just $9.6 billion in interest expenses.

Despite the challenges, the lower valuations of small-cap stocks may attract potential buyers. The Russell 2000's price-to-book multiple has dropped by 16 percent since the end of July, reaching 1.8, a historically low level.

Ryan Hammond of Goldman Sachs's US equity strategy team emphasised that economic growth remains a critical factor for the prospective returns of the Russell 2000. The US saw its growth accelerate to 2.5 percent in the second quarter, driven by strong consumption. The resilience of US consumers has bolstered hopes for a "soft landing" scenario in which inflation returns to the Fed's 2 percent target without triggering a recession.

In the event that the economy does indeed experience a soft landing, small-cap stocks may still have the potential to perform well, according to Hammond.

In the Australian setting, the picture is largely the same as the US.

The chart below illustrates the volatility of small caps, in which in times of economic optimism resulting from lower interest rate environments, small caps out perform the large caps, however, in times of economic downturn, small caps suffer greater than the larger listed players. 

ASX 100 vs S&P Small Ordinaries 



Source: FactSet

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