Earlier this year, small stocks were a big trade.
Among investors, the bet was that smaller U.S. businesses had less to lose in the global trade fight than big multinationals, and more to gain from the Trump administration’s tax cuts. With this backdrop, small stocks surged ahead of the giants that make up the Standard & Poor’s 500-stock index, beating them for much of the year.
That’s over now. Instead of being insulated, small companies are actually more likely than larger ones to be affected by investors’ big new worry: rising interest rates.
After peaking in August, the benchmark for so-called small caps, the Russell 2,000-stock index, is down more than 8 per cent. (That’s even after factoring in a big jump on Tuesday.) The S&P 500, by comparison, is down about 3 per cent.
Rising interest rates are problematic for smaller firms because they tend to have a much higher proportion of debt tied to a floating interest rate than larger companies do, and more debt in general. As rates climb, so will the interest on loans that small businesses carry.
“They’re more exposed to the rising rate environment,” said Marc Pouey, U.S. equity strategist with Bank of America Merrill Lynch.
Since late August, when small caps peaked, interest rates have marched higher. The yield on the 10-year Treasury note climbed to nearly 3.25 per cent this month from less than 3 per cent. And the Federal Reserve – which exerts control over short-term interest rates – has signaled that it will stick to its plans to keep raising rates in the face of strong economic conditions.
Roughly half the debt owed by Russell 2,000 companies is floating rate, which means interest payments will rise along with rates, according to research fromBank of America Merrill Lynch. That compares with just over 25 per cent floating rate debt forS.&P. 500 companies.
And starting in January, the aid to earnings growth that is attributable to the tax cut will fade. It’s another factor that could hit smaller companies harder than the bigger ones. Companies in another small-cap index, the Standard & Poor’s 600-stock index,paid an averaged effective tax rate of 36.5 per cent in 2017, compared with 27.1 per cent for large-cap stocks, according to research from JPMorgan Chase. That higher rate means smaller companies received a steeper cut in their tax rate under the tax overhaul, which lowered the corporate tax rate to 21 per cent from 35 per cent.
“You’ve got cost and margin pressure coming from a lot of different angles,” said George Pearkes, a strategist at Bespoke Investment Group.
Other issues, such as climbing labor costs, will also weigh disproportionately on companies with domestic operations. All of those elements are probably contributing to a flattening of earnings expectations among analysts who follow small-cap shares.
Add it all up and there’s a simple conclusion, said Pouey of Bank of America.
“We prefer large caps at this point.”