Small-cap stocks never participated in the 2023 market rally.
The lead small-cap index, the Russell 2000 (^RUT), is just above the flat line this year. Meanwhile the tech-heavy Nasdaq (^IXIC) is up nearly 30% and the S&P 500 (^GSPC) has risen 13%.
Recent work from Bank of America’s strategy team highlights a key issue facing small-cap companies that’s likely spooking investors: debt.
As the Fed has jacked interest rates at a historically fast pace, investors have grown concerned about how corporates and consumers would shift from the low interest rate regime of the 2010s to one where the cost of capital is much higher.
As the Bank of America chart shows, Russell 2000 companies are more at risk because they have a higher percentage of long-term debt maturing sooner, meaning they’ll have to pay higher interest rates in the near future if they need more capital to operate. This will likely shrink company profits and negatively impact earnings.
“Despite the fastest hiking cycle in 40+ years, we believe the impact to S&P 500 earnings will be manageable,” Bank of America’s equity strategy team wrote in a research note on Wednesday. “The real risk is in the Russell 2000.”
With the Fed likely holding interest rates higher for longer than initially expected, debt maturing could be a lingering issue for small caps, too.
“Unless interest rates reverse lower, interest expense should continue to eat into small-caps’ earnings,” Ed Clissold, Ned Davis Research chief US strategist, wrote in a research note on Sept. 21. “Lower expected earning growth for small-caps is one of the reasons we favor large-caps over small-caps.”
Clissold highlights that not all companies are necessarily reeling from the higher interest rate environment, though.
The Fed’s rate hikes sent interest expense for S&P 500 companies soaring. The expense rose 64.3% in the second quarter to $37.21 per share, the highest levels since the second quarter of 2008. But non-operating income, which includes income made from interest on cash balances, was at $6.86, up nearly 89% over the last four quarters. The difference between the expenses and the non-operating income is still below levels seen during the 2000s, per Ned Davis Research.
Megacap tech companies are fairing even better, too. Ned Davis Research found that over the past four quarters, Meta (META), Microsoft (MSFT), Adobe (ADBE), and Nvidia (NVDA) have made nearly $1 billion more in non-operating income than they’ve paid in interest expense.
So perhaps it’s not a surprise the 2023 rally has been largely megacap tech driven and has not included small caps much at all.
Josh Schafer is a reporter for Yahoo Finance.
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