Key Takeaways
- Small-cap stocks advanced amid a broad market rally on Thursday after the Federal Reserve lowered interest rates by half of a percentage point on Wednesday.
- Small caps are more likely than large companies to hold floating-rate debt, making the Fed’s rate cuts of particular importance to them.
- Small-cap earnings are still under pressure, one reason Bank of America analysts prefer mid-cap stocks to small caps in the near term.
Small-cap stocks were rising on Thursday amid a broad market rally after the Federal Reserve kicked off its long-awaited rate-cutting cycle with a big half-percentage point cut yesterday.
The small-cap Russell 2000 (RUT) jumped more than 2% at the open before paring some gains. Though the index was still up 1.5% in midday trading.
Small caps are expected to benefit more from lower interest rates than their large-cap peers because they are more likely to hold floating-rate debt. Almost one-third of outstanding Russell 2000 debt is floating-rate, compared with about a quarter for the mid-cap S&P 400 and just 7% for the S&P 500 (SPX), according to Goldman Sachs.
Small caps also have a far larger portion of their fixed-rate debt maturing in the next 5 years than the S&P 500, according to a Bank of America note on Thursday. The Fed’s decision on Wednesday, then, to charge out of the gate with a 50 basis-point cut significantly reduced small caps’ refinancing risk.
Risks to Small-Cap Earnings Linger
However, BofA analysts warn that lower rates may not be enough to give small caps the edge over larger companies. September and October tend to be difficult for small caps, they note, and this year’s election and economic precarity add extra uncertainty to the mix.
Plus, elevated rates and a slowing economy are still taking a toll on smaller businesses. The Russell 2000’s aggregate profit declined 10% year-over-year in the second quarter, and the index’s component companies mostly offered disappointing guidance.
For that reason, BofA analysts prefer mid-cap stocks in the near term, as they’ve tended to outperform small caps in times of uncertainty. Their superior earnings outlook and lesser rate sensitivity could offer investors more protection against an economic downturn or fewer-than-expected rate cuts.
In the small cap space, BofA favored value over growth stocks, and noted that larger small caps tend to outperform the smallest of the bunch in Fed cutting cycles.