US small-cap stocks rally harder than larger peers

US small-cap shares have rallied harder than their larger peers in June as investors bet on the strength of the domestic economy, but analysts warn that the momentum may flag as the impact of the Federal Reserve’s rate rises is felt more broadly.

The Russell 2000 index of small-cap companies, often regarded as a bellwether for broader economic expectations, has risen more than 8 per cent this month, hitting its highest level since the US regional banking crisis in March and outpacing the robust gains of the S&P 500 and the Nasdaq Composite over the same period.

The S&P and Nasdaq have climbed 5.9 per cent and 6.5 per cent respectively.

The move comes on the back of this year’s rally in US blue-chip equities, as gains for artificial intelligence-related stocks pushed Wall Street’s benchmark indices to their highest levels in more than a year. The S&P 500 has returned to bull market territory, tempting investors to jump into small cap companies.

“Eventually people start to look outside those leadership stocks and think, if this rally has legs, where does it go next?” said Steve Sosnick, chief strategist at Interactive Brokers. 

Small caps have been in demand after economic data at the start of the month suggested that the US labour market remained resilient in the face of the Federal Reserve’s aggressive monetary tightening.

The Russell 2000’s upward move is also an indication that investors are getting over the March US banking crisis, according to analysts. Bank stocks are the third-heaviest weighting in the index, behind industrials and healthcare.

“Seeing the index gain support suggests we’re finally moving beyond the worry that another bank-related headline is going to throw financial markets into a tailspin,” said Quincy Krosby, chief global strategist at LPL Financial.

However, some analysts said it was risky to bet on small caps’ sustained recovery because the full impact of rising borrowing costs has yet to materialise. The Fed has lifted its key rate from near-zero 15 months ago to between 5 per cent and 5.25 per cent, in an effort to tame raging inflation.

While the Fed paused its tightening on Wednesday, the central bank surprised investors by indicating it would probably raise rates twice before the end of the year to stamp out persistent inflation.

A consensus of analysts polled by Reuters suggests the US economy will enter recession in the second half of this year as high borrowing costs begin to feed through to households and businesses. 

In this environment, many predict that small caps will be the first to sell off. Marija Veitmane, senior multi-asset strategist at State Street Global Markets, said that, typically, it is “much more difficult for them to get funding, they usually have much smaller cash balances and cushions to protect themselves against difficult times”.

After its run-up, the Russell 2000 is trading at 24 times forward earnings this year, compared with 19 times for the S&P and 36 times for the Nasdaq. 

“Obviously [small caps] are cheap against large-cap tech, but if you look at the broader market we don’t think they’re that cheap or that under-owned,” said Emiel van den Heiligenberg, head of asset allocation at LGIM.

Yet even as the prospect of a hard landing remains, “being cautious on [US stock] markets is quite a nerve-racking exercise at the moment, when it goes up every day”, van den Heiligenberg said. 

“There is hardly a day when there are negative returns — that sucks people in, because not making any money when your neighbour is making money is for many people too frustrating to bear.”