In a notable surge, the Russell 2000 index (^RUT) experienced its most robust performance in more than two years, reflecting a renewed investor confidence in the Federal Reserve’s stance on interest rates. Despite a substantial 7.5% increase in the index, Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets, asserts that the small-cap sector still holds promising prospects, citing several traditional catalysts.
Calvasina highlighted the historical trend of small caps trailing during late economic cycles, emphasizing the attractiveness of this segment during uncertain times. She shared these insights during an interview with Yahoo Finance Live on Monday.
This strategic focus on small caps assumes greater significance in the current economic landscape. The latest job report unveiled on Friday revealed unemployment figures at their highest point in nearly two years. Recent data demonstrated a dip in activity within the US services sector to a five-month low. While the economy at large has demonstrated resilience, the emerging fissures on the surface could herald a phase of slower economic growth, as noted by Calvasina in a research note released on Monday.
In addition to the economic outlook, Calvasina pointed to other factors favoring small caps. There is a mounting confidence in the market that the Federal Reserve has concluded its interest rate hikes, which previously acted as a headwind for small caps. Concurrently, valuations within the index have become increasingly appealing.
Calvasina noted that the Russell 2000 index has not displayed such a marked discrepancy with the S&P 500 since the tech bubble of the late 1990s and early 2000s, prompting interest from multi-asset investors.
Yet, Calvasina acknowledged that the small-cap segment has lagged for valid reasons over the past year. A substantial proportion of these stocks have debt maturing within the next five years, surpassing most large-cap companies. This concern has been a focal point in discussions with investors, who are wary of how heightened debt financing costs could impact these companies and potentially hinder growth.
Ed Clissold, Chief US Strategist at Ned Davis Research, emphasized this concern, stating, “Unless interest rates reverse lower, interest expense should continue to eat into small-caps’ earnings.” He further noted that this is one of the driving factors in favoring large caps over small caps.
Nevertheless, Calvasina posited that small caps are poised to weather the higher rate environment. She underscored that not all of the debt matures in the coming year. RBC’s research indicates that 40% of small caps’ debt is slated to mature over the next two to five years, allowing room for potential rate adjustments as many anticipate the Federal Reserve to initiate interest rate cuts in 2024.
Furthermore, Calvasina turned attention to the historical context of interest rates, underscoring that the current effective rate remains historically low.
“While [the effective interest rate] is inching upwards and will continue to do so,” Calvasina stated, “it’s essential to recognize how much lower the starting point is today compared to past cycles.”
Source: Yahoo Finance
