US small cap stocks wilt in the heat of higher interest rates

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Small and midsize US stocks are struggling under the strain of high interest rates, as the Federal Reserve’s pledge to hold borrowing costs higher for longer threatens the weaker balance sheets of smaller companies.

The Russell 2000 small-cap index has fallen 11 per cent since its peak in July, while the S&P 500 is down 7 per cent over the same period. The small-cap index has fallen 7 per cent in September alone, leaving it more than 27 percentage points below its all-time high in 2021, compared with 11 percentage points for the S&P.

The underperformance highlights how smaller stocks are acutely feeling the effects of the Fed’s rate increases, at a time when some market watchers are questioning whether the transmission of interest rates to the economy has been blunted.

A key factor behind the small-cap decline is fast-rising interest costs at smaller companies, analysts say. Interest expenses for the S&P 600, another small-cap index, hit a record high in the latest batch of second-quarter earnings, according to data compiled by Ned Davis Research. 

“This is new, uncharted territory for small caps,” said Ed Clissold, Ned Davis’s US strategist, adding that smaller companies face the prospect of either rates staying high or the economy heading into recession.

Small caps have broadly weaker balance sheets than their large-cap counterparts. Debt as a multiple of profits is higher and interest payments take up a larger share of earnings.

Crucially, 30 per cent of Russell 2000 companies’ debt stock is floating-rate, exposing them to a rising rate environment. That is in contrast to 6 per cent for the S&P 500, according to Goldman Sachs.

Because of this floating-rate debt, “rising rates will pinch and defaults are likely to rise,” said Dec Mullarkey, managing director at investment firm SLC Management.

“More small companies tend to rely on bank lending, which has grown very restrictive,” he added. “Smaller companies tend to have more competition and less pricing power, which pressures margins as inflation stays high and wages increase. And, as growth slows, that will also amplify the margin squeeze.”

Compared with the S&P 500, broad small-cap indices contain more regional banks and industrials. These tend to suffer as investors lower their expectations for economic growth, as they have done recently, said Ryan Hammond of Goldman Sachs’s US equity strategy team.

The Russell 2000 also contains more life sciences firms than large-cap indices. The fact that the vast majority of such firms are unprofitable increases their sensitivity to growth and interest rates, he added.

While higher funding costs have been felt at bigger companies, the increase has been more muted. That, in part, reflects bigger firms’ lower cost of capital and the fact that many companies pushed out their debt maturities after the coronavirus pandemic began and central banks slashed borrowing costs.

Greater interest expenses have also been offset by large caps’ bigger cash hoards, which now generate more interest income thanks to higher rates. 

Among the main beneficiaries of rising interest income are the big technology companies, which dominate US large-cap stock indices.

In the 12 months to June, the so-called “magnificent seven” tech companies earned $13.3bn in interest income while paying out just $9.6bn in interest expenses, according to data from S&P Capital IQ. Since the Fed started raising rates early last year, Alphabet’s quarterly interest income has more than doubled, while its quarterly interest expense has fallen. 

Still, lower small-cap valuations could eventually lure in buyers. The two most important historical conditions for Russell 2000 returns are economic growth and starting valuations, said Goldman’s Hammond.

If the economy is heading for a soft landing, as Goldman expects, “I think the pieces are still in place” for small caps to perform well, he added.