While the media is focused on the Dow Jones Industrial Average reaching the 40,000 mark, there may be a different story unfolding if the Federal Reserve decides to lower interest rates. In this scenario, large-cap stocks could face some challenges, while small-cap stocks could finally have their moment to shine.
According to a report by Citi strategists, if interest rates are slashed, small and mid-cap stocks are expected to outperform their larger counterparts. Citi predicts that the Federal Reserve might aggressively ease rates by 200 basis points within the next year, bringing the target range for the federal-funds rate to 3.25%-3.5% from the current 5.25%-5.5% range.
Why would smaller companies benefit from this rate cut? The Citi strategists explain that smaller and mid-cap stocks have a higher proportion of floating-rate debt compared to larger companies. As a result, they would experience a reduction in interest-expense costs, leading to increased profitability.
In summary, if the Federal Reserve decides to cut interest rates, small and mid-cap stocks could be the surprising winners in the market. Their lower interest-expense costs due to higher floating-rate debt make them more resilient and potentially more profitable in this environment.
Over the past few years, larger companies have accumulated significant cash balances, earning substantial net interest income. However, Citi strategists predict that this trend will reverse as inflation cools and the Federal Reserve prepares to cut rates in the coming fall.
The prolonged period of higher interest rates has had a negative impact on smaller companies, but this is expected to change soon. Traders anticipate a 63% chance of a rate cut in September and almost 90% odds of a cut in December, following the presidential and congressional elections.
Mimi Duff, managing director with GenTrust, believes that small and mid-cap companies have already factored in the effects of higher interest rates and should perform well as long as rates stabilize.
According to Citi, if there are rate cuts, the S&P 500 (excluding financials) may see a decrease of around 2% in earnings over the next year. However, the mid-cap S&P 400 and small-cap S&P 600 indexes (also excluding financials) may experience a slight increase in profits. This is due to the trade-off between interest income on cash and interest expense on floating- and fixed-rate debt. The boost in earnings is particularly important considering the valuation gap between small and large stocks. In fact, experts believe that the significant discount at which small-caps trade compared to the S&P 500 is a positive sign for indexes like the Russell 2000 and S&P 600.
According to a report by equity and quant strategists at BofA Securities, the Russell 2000 is currently trading at a lower valuation of 14.5 times forward earnings estimates, below its historical average. This discrepancy suggests that small-cap stocks may outperform larger caps in the coming decade.
The strategists also believe that cyclical sectors are poised for better performance compared to defensive sectors, as the outlook for rate cuts and the broader economy improves. They anticipate a recovery in manufacturing and have identified industrials and energy as the top small-cap sectors.
Furthermore, the BofA strategists highlighted industrials Titan International, Hub Group, and Moog, power-conversion company Advanced Energy Industries, and utility Otter Tail as attractive small-cap stocks. These sectors have experienced a significant increase in sentiment and are currently trading at low valuations.
According to Neil Hennessey, chief market strategist with Hennessy Funds, midsize companies could be in a favorable position as interest rates decrease. Hennessey believes that many investors, who have a significant amount of cash on hand, will be looking to diversify their investments beyond the top-performing stocks in the S&P 500.
“There is a significant amount of money waiting on the sidelines. As interest rates start to decline, it will flow into smaller value stocks,” Hennessey explained.
Hennessy Funds’ Hennessy Cornerstone Mid Cap 30 Fund holds companies that Hennessey believes will benefit from a stable economy. These companies are large enough to potentially make strategic acquisitions of smaller competitors, yet small enough to be attractive targets for larger companies looking for acquisitions.
The fund’s managers employ a quantitative strategy for stock selection, which has resulted in a significant allocation to consumer-oriented companies. These are precisely the types of firms that would benefit the most from lower interest rates and decreasing inflation pressures. As of the end of the first quarter, top 10 holdings included retailers such as Gap, Abercrombie & Fitch, Sprouts Farmers Market, and Guess?.