Small Cap Equity Opportunities & Risks in an Easing Cycle

Rate cuts raising interest in Small

September 27, 2024

The Fed’s aggressive interest rate cut last week has led to an uptick in conversations about Small Cap investing. Interest rate cuts have historically led to Small Cap outperformance, but it is no secret that past relationships feel different today, so we wanted to highlight our views. Empirically, Small Caps do better when rates decline because they have more debt, and debt at variable rates. Small Value in particular sees an outsized impact from Fed policy, given the space’s increased exposure to interest rates via its high regional bank weight. M&A, already off to a very strong year, should see tailwinds from lower rates, which also benefits Small. If the Fed achieves a soft landing, lower rates’ boost to domestic investment activity, which Small Caps have outsized exposure to, should also lift the space. Vast performance and valuation gaps are waiving a “welcome!” sign if lower interest rates prove to be the long-awaited catalyst for regime change from mega cap tech – as if to say, “Come in, we have the quality you were seeking in the Mag7 at rock bottom prices”.

This leads us to a few caveats. The most cited catalyst, relief for debt-laden Small Caps, leads to outperformance for lower-quality stocks– something we are particularly wary of as the Fed cuts rates on softening economic conditions. The benefit to Small Value, given its Financials weight, presents its own concern, as these stocks have high commercial real estate exposure, a risk that needs to be well-managed by investors. We advocate for investing via active management to avoid these inherent pitfalls of the index or investing in a higher quality index such as the S&P 600 over the Russell 2000, which excludes non-earners. But what if the economy falters, is Small Cap a dangerous place to be? We believe the performance gap between Large and Small, particularly for Small Value, will act as a buffer as it did in 2022. With the S&P 500 down 18.1% over that year, the Russell 2000 Value outperformed nearly the entire year, ending with 363 bps of outperformance, and outperformed the NASDAQ by 1,806 bps[1] – due to valuation gaps, Small Value was simply safer. Today, we view the space with dual-pronged benefits: there is safety in Small’s lower multiples if markets falter, as well as quality companies whose stocks are set to benefit as lower rates work their way through the US economy, creating an environment where Small can shine.

We will continue to share our findings as we further develop any research around this topic.  If you’d like to join the discussion, please don’t hesitate to reach out to us.

[1] Total return. Source: FactSet