Stock Market

Small-Cap Stocks Plunge as Debt Refinancing Concerns Grow Amid Economic Uncertainty

In the realm of US equities, small-cap stocks are presenting an attractive valuation, the likes of which have not been seen in many years. However, optimism is marred by the substantial levels of debt that loom on the horizon. Small firms, constituting the Russell 2000 Index, are facing a daunting task: refinancing a staggering $832 billion in debt, with an overwhelming 75%, approximately $620 billion, needing action by 2029, according to Bloomberg data. In stark contrast, larger corporations in the S&P 500 Index have a less onerous 50% due in the same timeframe.

Senior multi-asset strategist at State Street Global Markets, Marija Veitmane, conveys caution, “We won’t be buying yet, despite the lure of attractive valuations.” Veitmane points out the vulnerabilities of small caps: their heightened sensitivity to economic downturns, costlier funding, and the likely compression of margins.

Small caps, often lacking the size to borrow from bond markets, are burdened with floating-rate debt primarily constituted by loans. This structure means they face immediate interest rate adjustments post-Federal Reserve hikes, unlike large corporations with fixed-rate bond debts, which can delay the impact of rate increases.

Moreover, the fate of small-cap stocks is closely tied to the economy's performance. With the economic environment currently shrouded in considerably perplexing uncertainties and the threat of inflation persisting longer than previously anticipated, Wall Street experts exercise caution toward these riskier investments—even when valuations seem tempting.

According to Bloomberg, the price-to-sales ratio of the Russell 2000, when juxtaposed against the S&P 500, is hovering near its lowest point since 2003, barring for the extraordinary circumstances of the Covid-19 pandemic in 2020. Market players, however, believe the index demands flawless conditions and a significant uptick in economic growth to spark a potential surge in prices.

Guy Miller, chief market strategist at Zurich Insurance Co, favors larger corporations, stating, “The bigger, quality names have lofty prices for a reason.” These larger entities don't typically encounter the same funding challenges as their smaller counterparts and possess a far less pronounced dependency on interest rate policy nuances.

Lag in Small-Cap Performance

The narrative of underperformance is commonplace for small-cap stocks. The Russell 2000 saw an uninspired growth of just 1.6% this year, a feeble performance especially when juxtaposed with the S&P 500's leap of 9.5%. The trend is no recent phenomenon as the S&P 500's overall performance has far outshone that of the Russell 2000 since early 2023.

This reluctance toward small-caps is not baseless. The Russell 2000 has failed to reach new peaks for over two and a half years, the longest period of stagnation since the global financial crisis. In contrast, the S&P 500, with a robust economy fueling its stance, has achieved and surpassed record highs 22 times in the year 2024 alone.

The small-cap segment is now intricately linked with the movements of interest rates and the unstable condition of the economy. While the equity market rally at the end of April showed signs of life, there’s a prevailing sense of doubt clouding investors' confidence. The preference among investors has been a flight to safety, represented by the Magnificent Seven technology mega-caps, which are typically viewed as more secure in tumultuous economic spells. This flight has led to a 9% surge in the Bloomberg Magnificent 7 Total Return Index over the past three weeks. Conversely, hedge funds are witnessing one of their largest net short positions on record for Russell 2000 futures, cited data from Ned Davis Research.

While earnings projections remain low, with an increase of a mere 0.3% for the Russell 2000 in the first quarter compared to the S&P 500's 4% surge, strategists like Michael Casper and Gina Martin Adams anticipate an erratic recovery, potentially leaving the small-cap index prone to volatility for the remainder of 2024.

Bank of America's analysis exposes a grim reality: even if interest rates maintain their current levels, the operating earnings of small-cap firms, excluding the finance sector, face a predicted reduction of 32% over the next half-decade. This is largely due to nearly half of their debt being short-term or at floating rates.

The Burden of Non-Profitable Small Caps

It’s not just the debt that adds to the woes of small-caps. Bloomberg’s data suggests a worrying trend of unprofitability, with 42% of Russell 2000 companies currently in the red, a sharp rise from less than 20% in the mid-1990s. “The quality of companies in the Russell is significantly worse than it was two decades ago,” comments Hugh Grieves, a fund manager for the Premier Miton US Opportunities fund. He continues with a bleak outlook on unprofitable companies: “You’ve had a lot more companies go public that have never made a profit and probably never will.”

Yet, not all market analysts agree that small-cap stocks should be uniformly avoided. David Lefkowitz, head of US equities at UBS Global Wealth Management, maintains a belief in potential tailwinds for this sector, hypothesizing that decreasing interest rates by the year's end could bolster it. Moreover, he expects the anticipated amplification in business activity to translate into stronger earnings.

“It’s not that small caps are intrinsically poor investments; it's just that large caps continue to perform better in comparison,” asserts Lefkowitz, who shifted his stance to overweight on the small-cap sector as of December.

Bank of America's strategist Jill Carey Hall advises clients to adopt a selective approach, finding certain segments within the energy, materials, and industrials sectors relatively more appealing due to their economic recovery sensitivity and less daunting refinancing pitfalls. Despite such advice, investors seem to be holding back, awaiting greater assurance on inflation’s downturn and the Fed's readiness to initiate interest rate cuts.

Grieves of Premier Miton takes a broader view, suggesting that the focus on equities isn't purely about small-caps. He emphasizes the continued dominance of the tech titans that have persistently outperformed. According to Grieves, “What it keeps coming back to is the Magnificent Seven. Once they stop outperforming, that’s when you’ll see fund managers start to get more excited about small caps.”

An intricate web of fiscal demands and cautious investor sentiments captures the current state of small-cap stocks. With the help of expert analyses from Bloomberg, Sujata Rao, Jan-Patrick Barnert, Elena Popina, and Jessica Menton bring light to a complex investment scenario where navigating the landscape of small-caps requires sagacious decision-making and solid confidence in the economic forecast.

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