What Does Fed Action Imply for Small Caps?

Key Points

• Small caps are typically more sensitive to interest rates than larger-cap firms since these smaller firms use more external financing for growth.
• Investors should expect a disproportionate impact on small caps from any perceived changes in future Federal Reserve (Fed) policy.
• However, slowing economic activity has a greater impact on small caps relative to larger caps.
• So for now, small cap investors must work through the portfolio implications of these two competing forces.

Revised Expectations About Interest Rates Set the Stage for Small Caps

Ever since the latest Consumer Price Index (CPI) was released on July 11, the most hawkish investor has had to concede that inflation rates were decelerating enough for the Fed to start cutting rates this year. After several disappointing reports earlier this year, more recent inflation reports were more encouraging to investors and setting things up for a small cap recovery.

The most recent and more comprehensive inflation report reiterated the good news. The Fed’s preferred inflation measure, the Personal Consumption Expenditure Index (PCE) showed inflation rose a mere 0.07% as goods prices declined 0.17% but were offset by services prices up by 0.20%. Inflation continues to moderate and is slowly approaching the Fed’s target. The underlying details have improved. Rent prices rose 0.26% month-to-month, back to pre-pandemic averages and goods prices declined for the second consecutive month as consumers reduced demand for goods purchases. Further, services prices are moderating as most services ex-housing have eased or outright declined.

Inflation continues to moderate and is slowly approaching the Fed’s target. We should expect the Fed to highlight the slowdown in hiring as one reason to cut rates at the September meeting. As for business activity, real disposable income per capita continues to rise. This gives consumers the ability to keep spending despite high price levels. So, we are paying more, but we are getting paid more.

Competing Forces on Small Caps

As the market came around to the likelihood that the Fed will cut rates a couple of times this year, risk appetite improved, and small caps rallied. However, investors must work through the implications of the current macro landscape for positioning portfolios for the rest of the year. Small caps often perform well in a lower interest rate regime, but small caps often feel the impact of a slowing economy As the market came around to the likelihood that the Fed will cut rates a couple of times this year, risk appetite improved, and small caps rallied. However, investors must work through the implications of the current macro landscape for positioning portfolios for the rest of the year. Small caps often perform well in a lower interest rate regime, but small caps often feel the impact of a slowing economy. See our blog from earlier this month on the big gains for small caps written by our Chief Technical Strategist, Adam Turnquist.

From today’s Automatic Data Processing (ADP) release, the slowdown in business activity is more pronounced for small firms. Payrolls at small businesses grew much slower than at larger firms.

Small Firms Grew Payrolls at a Much Slower Pace

Source: LPL Research, Automatic Data Processing, 07/31/24

We do believe the Fed will cut interest rates in September and December. Further, if the economy is slowing more than expected, the Fed could cut rates in November as well. Falling interest rates will help small caps, but slowing economic activity has a greater impact on small caps relative to larger caps.

In the last few years, the Russell 2000 and the ISM Composite index have had a close connection. Investors should watch the ISM numbers closely as a leading indicator.

Slower Growth Would Signal Headwinds for Small Caps

Source: LPL Research, Institute of Supply Management, WSJ, 07/31/24

Conclusion

Investors are interested in taking more risk as the so-called soft landing looks more likely. We have an economy with low unemployment, with rising wages, decelerating inflation, and a Fed on the cusp of cutting rates. Of course, political uncertainty and headwinds from geopolitical risks could rain on that parade and that’s why investors should exhibit discernment in a market like this. And when challenges come, small cap firms are the first to feel the weight.