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  • Writer's pictureJ
    • 2 days ago
    • 12 min read

US Fed Rate Cuts: The Beginning of a Slight Rotation to Small-Cap Stocks?


As I (and the wider financial markets) anticipate interest rate cuts by the Federal Reserve, small-cap stocks might be poised for a resurgence. Lower borrowing costs, higher debt sensitivity, and shifting investment strategies among institutional investors could perhaps create favorable conditions for this sector. Recent developments indicate that institutional money managers, after missing significant gains in the tech sector, are actively seeking new avenues for growth. This convergence of factors might just set the stage for a notable shift from fixed income and large-cap stocks to small-cap stocks.


UPDATE : Just as I finished this note, the US Federal Reserve cut the Fedfunds rate with 50 basis points (Yahoo Finance). Keep this in mind whilst reading this note.

 

DISCLAIMER: Please note that the information provided in this article is for informational purposes only and should not be construed as financial or investment advice.

 

Main Sections of the Note

  1. Historical Performance: Large-Caps vs Small-Caps

  2. Trillions on the Sidelines in the US

  3. Debt Sensitivity Dynamics: A Simple, Comparative Analysis

  4. Momentum for a Rotation to Small-Caps

  5. Final Words

 

Historical Performance: Large-Caps vs Small-Caps

Looking at the performances of large-caps versus small-caps, there are some interesting observations that can be made. I have compiled data for the US (S&P 500 and Russell 2000) as well as for Sweden (OMXS30 and OMXSSCPI).


USA

As can be seen in Chart 1, the S&P 500 (i.e large- s) and the Russell 2000 (i.e small-caps) have more or less had quite similar index performances for the better part of this millennia. The real divergence started in the middle of 2021, and accelerated in from Q4 2022 onwards. I have added a little marker for when ChatGPT became publicly available and this is particularly interesting since it shows that the S&P 500 really started to pull away from this moment onwards. The higher interest rates in the last two years, primarily to combat inflation, clearly put a dent in the performance of the Russell 2000.

This pull-away by the S&P 500 can mostly be attributed to the Magnificent 7, as can be seen in Chart 2. Generative AI has so far had a notable appreciation impact on the largest tech companies but not yet on small-cap companies. I do not think it's implausible however that once generative AI becomes "normalized", in the form of LLMs essentially being more of a commodity, this will also start to increase the general productivity levels across the majority of companies in the US. If so, this could be an argument of value appreciation for small-cap stocks. Long-term, I don't ever think the Russell 2000 will completely catch up to the S&P 500 from here, mainly due to the exponential pace set by the largest tech companies when it comes to the development of new technologies. The network and scaling benefits as this continues for these behemoth companies will be enormous. Notwithstanding, in the short-term, I do see a possibility of the Russell 2000 appreciating more relative to the S&P 500.


Sweden

Looking towards Sweden, there are some similarities but most notably some huge differences compared to the US. In Chart 3, one can see that OMXSSPI (small-caps) has very clearly outperformed OMXS30 (large-caps). This outperformance really started when interest rates where very low (and even negative), which goes to show that the debt sensitivity for small-caps really can work as an extra lever in terms of its impact on net profits and free cash flow and thus stock performance. More on that later in this note! Unlike the US, Sweden lacks the same major tech companies driving its large-cap market. As a result, Swedish large-caps have not benefited from the widespread excitement and value appreciation associated with the AI revolution.


Trillions on the Sidelines in the US

There's a lot of money just sitting on the sidelines right now. And we're talking about potentially trillions of dollars. So, what happened? Many investors missed out on the massive gains in tech stocks throughout 2023. The rally was so concentrated around a few mega-cap names that plenty of institutional investors were left playing catch-up, searching for where to put their cash to work next. According to the Financial Times (2024), only 29% of active U.S. equity funds managed to beat their benchmarks in the first half of 2024. As can be seen below, more than $6.3 trillion are currently sitting in money market funds. For an investor having money placed here, this would mean about 5% returns per year since 2022 (Investment Company Institute, 2024). This risk-aversion among investors has caused some problems when the S&P 500 has shot upwards in the same time frame. In other words, there might be a lot of capital seeking to make its way back into the stock market, especially so considering Fed rate cuts are on the horizon.


Money market in the US

Institutional Pressure Mounts for Money Managers

And it’s not just everyday investors feeling the heat. Even the pros are under pressure. Take JPMorgan's top strategist, Marko Kolanovic. According to MarketWatch (2024), Kolanovic advised clients to underweight equities, leading to some pretty painful underperformance just as the market soared. It really highlights how high the stakes are for institutional investors who now need to find new opportunities to make up for lost ground. Marko Kolanovic "left" JP Morgan earlier this year.

After all, if you get paid millions of dollars to deliver for very rich people and you do a worse job than an average retail investor, you're bound to get some heat no matter how senior you are. I would not be surprised if there's some more very senior money managers on Wall Street feeling the heat right now just like Marko Kolanovic did. In fact, a MarketWatch (2024) article pointed out how a fear of missing out (FOMO) could even spark a "parabolic melt-up" in the market. Fund manager Dan Ives noted that investor sentiment could flip quickly, leading to accelerated inflows into undervalued sectors. “We believe a parabolic rally could be on the horizon as investors rush to catch up,” he stated. This lines up with the idea of capital rotating into small-cap stocks as investors look to make up for missed gains. And let’s not forget the valuation angle. The forward price-to-earnings (P/E) ratio for the Russell 2000 is currently around 18x, compared to 22x for the S&P 500 and 28x for the NASDAQ-100 (FactSet, 2023). As the Financial Times highlighted, this disparity is making small-cap stocks increasingly appealing, especially to investors who are eyeing sectors that haven’t been fully priced in yet. This could be setting the stage for a rotation into small-caps in the near future. Now, I don't believe we'll see a huge rally, since I'm "only" cautiously bullish in this market. I want to make one thing very clear. Every scenario and what I'm discussing here is dependent on the condition that there is no recession coming in the near future. If it does, small caps are usually the first victim, and thus the worst performer.


Debt Sensitivity Dynamics: A Simple, Comparative Analysis

Small-cap companies often carry more debt compared to their large-cap counterparts. They also have a much bigger proportion of their debt with a floating rate. This means that changes in interest rates can impact them more significantly. Let’s break down this idea with some numbers, using a very simplified example.

Imagine we have two companies; SmallCap Industries and LargeCap Corporation.


The assumptions are as follows:

  1. SmallCap Industries has an EBITDA of $178.6 million and a net income of $59.5 million.

  2. LargeCap Corporation has an EBITDA of $8.57 billion and a net income of $3.8 billion.

  3. The Federal Reserve transitions to cutting short-term rates, impacting mostly impacting floating rates. For the sake of simplicity, in my example I will assume only floating rates are affected by a decreased interest rate. The decrease is 100 basis points for both companies.

  4. Initial interest rates for SmallCap Industries and LargeCap Corporation are 6% and 4%, respectively, reflecting higher credit risk for SmallCap Industries.

These figures are based on data retrieved for companies in both indices, however I have made some assumptions when it comes to the exact figures. The somewhat representative EBIDTA and net income for the two companies have been reverse-calculated using market capitalization, P/E ratios and profitability margins for the companies in the indices. For perfectly indicative, representative EBITDA and net income, one would need access to the Bloomberg Terminal or something similar. For this simplified example, I have used the information I could find directly on the internet. I do believe the values are realistic though and will serve to show the debt dynamics at play for large-cap vs small-cap. I will use the debt-to-EBITDA ratios for the Russell 2000 (6.5x) and S&P 500 (2.3x) and the proportions of fixed and floating-rate debt provided in the table above to calculate the impact of a 1% interest rate cut. Step 1: Calculating Total Debt Using Debt-to-EBITDA Ratios

SmallCap Industries
- EBITDA = $178.6 million
- Debt-to-EBITDA Ratio: 6.5x
  Total Debt: 6.5 x 178.6 = 1 160.9 million
LargeCap Corporation
- EBITDA = 8.57 billion
- Debt-to-EBITDA Ratio: 2.3x
  Total Debt: 2.3 x 8,570 = 19 711 million

Step 2: Breakdown of Fixed and Floating-Rate Debt

SmallCap Industries
- Floating-Rate Debt (45%): 1 160.9 × 0.45 = 522.4 million
- Fixed-Rate Debt (55%): 1 160.9 × 0.55 = 638.5 million
- Interest Rate = 6%
LargeCap Corporation
- Floating-Rate Debt (9%): 19 711 × 0.09 = 1 774 million
- Fixed-Rate Debt (91%): 19 711 × 0.91 = 17 937 million
- Interest Rate = 4%

Step 3: Initial Interest Expense Calculations (Before Rate Decrease)

SmallCap Industries
- Floating Rate Interest Expense: 522.4 × 0.06 = 31.344 million
- Fixed Rate Interest Expense: 638.5 × 0.06 = 38.31 million
Total Initial Interest Expense: 31.344 + 38.31 = 69.654 million
LargeCap Corporation
- Floating Rate Interest Expense: 1 774 × 0.04 = 70.96 million
- Fixed Rate Interest Expense: 17 937 × 0.04 = 717.48 million
Total Initial Interest Expense: 70.96 + 717.48 = 788.44 million

Step 4: Impact of 1% (100 basis points) Interest Rate Decrease

SmallCap Industries
- New Floating Interest Rate = 5%
- New Floating Interest Expense: 522.4 x 0.05 = 26.12 million
- Fixed Interest Expense: Remains at 38.31 million
- New Total Interest Expenses: 26.12 + 38.31 = 64.43 million
- Annual Savings: 69.654 - 64.43 = 5.224 million
_____________________________________________________________
Percentage Increase in Net Income: 
(5.224/59.5) x 100 = 8.78% lift in Net Income
LargeCap Corporation
New Floating Interest Rate = 3%
New Floating Interest Expense: 1 774 x 0.03 = 53.22 million
Fixed Interest Expense: Remains at 717.48 million
New Total Interest Expenses: 53.22 + 717.48 = 770.7 million
Annual Savings: 788.44 - 770.7 = 17.74 million
_____________________________________________________________
Percentage Increase in Net Income: 
(17.74/3 800) x 100 = 0.47% lift in Net Income

Summary:

SmallCap Industries
Annual Savings: 5.224 million
Net Income Increase: 8.78%

LargeCap Corporation
Annual Savings: 17.74 million
Net Income Increase: 0.47%

If one do the same calculations but but this time assuming a 200 basis points (2%) decrease in the floating rate for both companies, we get the following results:

SmallCap Industries
Annual Savings: 10.448 million
Net Income Increase: 17.55%

LargeCap Corporation
Annual Savings: 35.48 million
Net Income Increase: 0.93%

This calculation shows why small-cap companies benefit more from interest rate cuts than large-cap firms.

Small-cap companies generally have more debt relative to their earnings (higher leverage) and of that debt, a larger proportion is floating-rate debt. This makes them much more sensitive to changes in interest rates. In the simplified example, a 1% rate decrease led to an 8.78% increase in net income for the small-cap company, compared to just 0.47% for the large-cap.


This difference underscores how small-caps can see a bigger boost in profitability when rates drop. For investors, this suggests that small-cap stocks may offer greater upside potential during periods of falling rates due to their higher interest rate sensitivity.


Momentum for a Rotation to Small-Caps

Given the current economic landscape, I believe the anticipated Federal Reserve rate cuts could serve as a catalyst for shifting investor focus from large-cap to small-cap stocks. Small-cap companies, which are often more domestically focused and carry higher levels of debt, could potentially outperform their large-cap counterparts in a lower interest rate environment.


One additional factor likely to fuel this shift toward small-caps is the potential rotation from bonds and fixed income to stocks. With bond yields becoming less attractive as interest rates decline, investors who had previously prioritized bonds during periods of higher rates may now be considering reallocating to stocks. Small-cap stocks, in particular, could offer an appealing opportunity for those seeking to boost returns. According to the Wall Street Journal, as interest rates peak, many investors are reassessing their bond holdings, with the expectation of declining yields prompting a search for better returns in equity markets.


"As the prospect of falling interest rates reduces the total return potential for bonds, investors are increasingly looking toward equities, especially undervalued sectors," commented a senior portfolio manager (Wall Street Journal, 2024).

Similarly, a Bloomberg report underscores that large institutional investors are beginning to adjust their portfolios by reducing allocations to fixed-income assets in favor of stocks. This shift is being driven by expectations of central banks easing monetary policies, which would lower bond yields and likely boost stock valuations, making equities more attractive.


This rotation from bonds to stocks could inject fresh capital into the equity markets, providing further support to small-cap stocks that are well-positioned for growth. A Franklin Templeton report highlights that a shift into undervalued sectors, such as small-cap stocks, seems inevitable. According to the report:

"As valuations in certain sectors become stretched, we expect a natural rotation into areas that have lagged but still offer strong fundamentals and growth potential."

This viewpoint is also echoed by Tom Lee of Fundstrat, who has stated that the market is on the verge of a rotation into small-cap stocks. In one of his interviews, Lee commented:

"We're at a turning point where the market is primed for a rotation. Small-cap stocks have lagged, but with the Fed’s expected rate cuts and investors eager to improve their performance, small-caps could see substantial inflows" (CNBC interview, 2024).

A Reuters article further notes that small-cap stocks have transitioned from being seen as "dead money" to becoming Wall Street darlings. The Russell 2000 index, which tracks small-cap stocks, recently outperformed the S&P 500, signalling growing investor interest in this sector.


Analysts point to several factors driving this shift:

  • Attractive Valuations: Small-cap stocks trade at lower forward P/E ratios compared to large-cap stocks, making them more appealing to value-focused investors.

  • Economic Recovery: Small-cap companies, being more closely tied to domestic economic conditions, are well-positioned to benefit from economic recoveries.

  • Interest Rate Sensitivity: Lower interest rates reduce borrowing costs for heavily leveraged small-cap firms, providing a direct boost to profitability.


Extending the Analysis to the Swedish and Nordic Markets

The US dynamics discussed above also apply to the Swedish and broader Nordic markets, particularly in small-cap companies, which tend to have higher leverage and a larger portion of floating-rate debt. Swedish small-caps, as represented by the OMXSSPI, have historically outperformed large-caps during periods of low interest rates, as demonstrated in Chart 3.


In the coming months, the Riksbank, Sweden’s central bank, is expected to start easing monetary policy in line with global central banks (Riksbank, 2024). As rates decline, small-cap companies in Sweden and the Nordics could see significant financial improvement, just as US small-caps are poised to benefit. This is especially true given that Swedish small-caps are more domestically focused, making them highly sensitive to domestic economic rebounds and falling borrowing costs.

Unlike the US, Sweden does not have large tech firms driving large-cap growth, this making the relative valuation of Swedish small-caps compared to large-caps quite attractive. This could make them a potential target for capital inflows once rates start to decline. If I had to forecast which of Russell 2000 and OMXSSCPI will perform the best relative to S&P 500 and OMXS30 respectively, I would go with OMXSSCPI versus OMXS30.


Final Words

There are many good arguments as to why Russell 2000 and other small-caps indices in well-developed capital markets with strong economic fundamentals might appreciate in the near months as the rate cut cycle begins. The extent to which they will perform versus large-cap stocks will largely depend on the tech mega-cap companies. The AI revolution might be so generational and the actual beginning of a fourth industrial revolution that the companies driving this change pull further away, regardless of other factors. If this is the case, the S&P 500 will continue to outperform the Russell 2000 in the US no matter what due to scale economy as well as implied network effects. That said, placing a small speculative allocation toward a broad small-cap mutual fund or ETF could be an interesting move. As mentioned earlier though but is worth re-iterating, it is dependent on the condition that there is no recession coming in the near future. If it does, small caps are usually the first victim, and thus the worst performer.


 

DISCLAIMER: Please note that the information provided in this article is for informational purposes only and should not be construed as financial or investment advice.


All investments carry risk, and the value of your investment can go up or down. Past performance is not a reliable indicator of future results, and no guarantees can be made regarding future market movements.

 

By J



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