The recent decline in smallcap stocks has wiped out the gains made in the first quarter of the year, with the Russell 2000 down 5.7% in April alone. This is a stark contrast to the 4.8% increase seen in the first quarter, signaling potential trouble ahead for smaller shares. The underperformance of smallcaps is evident when compared to the S&P 500’s 7.4% rally, with smallcaps now down 1.2% for the year.
The Federal Reserve’s decision to delay interest rate cuts until September has put small companies at a disadvantage. The promise of growing profits for these companies is pushed further into the future, making it difficult for them to compete in the current market. The central bank’s benchmark fed funds rate, currently at 5.25%-5.50%, poses a significant risk to smaller companies, as it affects their ability to refinance debt and operate effectively.
According to Bank of America equity and quantitative strategist Jill Carey Hall, smallcaps are likely to face turmoil for the rest of the year if interest rates remain unchanged. The longer the delay in rate cuts, the lower investors’ confidence will be in the likelihood of cuts happening at all. This uncertainty can have a detrimental impact on smallcap operating earnings, with debt servicing becoming increasingly challenging.
Certain sectors, such as real estate, technology, materials, industrial, and energy stocks, will feel the brunt of the effect of interest rates on smallcaps. These industries are more vulnerable to changes in rates and are likely to see a decline in operating earnings if rates are not cut. However, the impact may vary depending on the level of debt and the dependency on short-term or floating-rate debt within each sector.
Despite the challenges faced by smallcap stocks, some analysts believe that the strong economy may help support a more positive outcome for the Russell 2000 in 2024. Small cap strategist Steven DeSanctis suggests that small cap companies’ balance sheets remain strong, which could help them weather the storm of higher interest rates. The close tie between small caps and the U.S. economy also indicates a potential for better-than-expected earnings growth, even without rate cuts.
The impact of interest rates on smallcap stocks is significant and could have long-lasting effects on the performance of these companies. It is essential for investors to carefully consider the implications of interest rate decisions on their smallcap investments and adjust their strategies accordingly to mitigate risks and maximize returns.