Don't bet on stock market rotation as small caps historically suffer when rates fall, Barclays says

• Small caps have historically declined before and after the first interest rate cut, Barclays reported.

• This runs counter to the growing narrative that the easing cycle will boost small caps, the bank said.

• Wall Street is divided on whether the sector's recovery can continue.

Small caps are seeing renewed interest on Wall Street, but there is no reason to expect the sector to rise, Barclays writes.

In fact, strategists led by Venu Krishna have found that tracking small caps Russell 2000 generally decreased once rate cuts began.

“We believe this runs counter to the popular narrative that the start of a rate-cutting cycle signals a sustained uptrend for small caps relative to large caps,” the note said.

The authors compared Russell's performance to that of S&P 500 over 13 easing cycles between 1980 and 2020. While the note acknowledges a range of outcomes, a general downward trend was evident in the 150 days before and after the first reduction.

Their findings contradict many prevailing views on Wall Street, where growing bets on lower interest rates have sent investors flocking to small-cap stocks. Last Thursday, the Russell index gained 3.6%, even as the tech-heavy Nasdaq lost 2%.

Many expect these stocks to benefit from lower borrowing costs, given their high exposure to debt. The rotation into small caps was sparked by June’s surprisingly calm inflation report, which boosted confidence that the Federal Reserve would cut rates as early as September.

The Russel faces 40% increase by August, given the oversold nature of its assets, Fundstat's Tom Lee predicted this week.

Barclays, however, explained why this may not have been the case in the past. Lower interest rates could go some way to easing debt burdens, but they can also signal a slowing economy, which favours exposure to large caps.

“Small caps also continue to face many other headwinds, including lower EPS forward revisions than their large cap peers, higher volatility (which is not appreciated when the yield curve comes out of inversion and in election years), and increased vulnerability to trade tensions despite an increased focus on domestic sales,” Barclays wrote.

Skeptics agree. Market veteran Ed Yardeni wrote this week that the small-cap market has no room to run, given the sector's mediocre earnings, revenues and profit margins.

Meanwhile, others have acknowledged the gathering but questioned its ability to continue.

“When the Fed embarks on a rate-cutting cycle, markets tend to cheer at the beginning and even for a short period after the cuts begin. But if that rate-cutting cycle occurs in concert with slowing economic data, disappointing earnings, or rapid multiple compression, small caps would likely lose steam quickly,” Liz Young Thomas, SoFi’s chief investment strategist, said in a written commentary.

The story continues

She added: “Not to mention that the Fed typically cuts rates late in the economic cycle, not early in the cycle, when small caps tend to be in the spotlight.”

Read the original article on Business Insider

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