The segment has hit a rout as improving trade prospects and rising rates curb its appeal
The worst rout to hit small, US-focused firms in years represents another collapsed pillar of support for the country’s nine-year bull market.
“[I]nvestors are being forced to reassess longstanding bets—including in small caps, emerging markets and technology stocks—that are faltering after thriving for years in a low-rate environment,” reported the Wall Street Journal.
The Russell 2000 index of small-cap stocks, which had hit records throughout August, entered correction territory last week — the first time it has done so since 2016. That has produced an unusual situation of both large and small caps falling together.
Around the second half of the year, escalating trade tensions stoked fears of a potential growth slowdown among investors. Many thought small caps would be better position to weather trade threats than multinational stocks, which are more driven by movements in global trade. That collective thinking resulted in inflows that pushed small caps past their larger counterparts.
But the recent trade deals that the US ironed out with Canada and Mexico, as well as the European Union, has undermined the case for small caps. Concerns surrounding tightening monetary policy have also put pressure on the broader stock market.
“In the past few months, analysts at Morgan Stanley, Bank of America Merrill Lynch and PIMCO have warned that the small-cap rally looked vulnerable to a reversal,” the Journal said. That’s partly because small caps frequently slip near the end of economic expansions, when pressures like rising wages and borrowing costs emerge.
Leverage was of particular concern to some analysts, who saw it as a potentially big pressure point for small caps over the next few years. Bank of America Merrill Lynch pointed to the Russell 2000’s corporate debt which, at 3.5 times Ebitda, is close to all-time highs hit in the early 2000s. Jill Carey Hall, US equity strategist at Bank of America Merrill Lynch, called leverage “one of the biggest risks” small caps face over the medium term.
Morgan Stanley, meanwhile, was among those who saw an overdue pullback in small caps, along with other groups in the stock market that thrived earlier this year. The bank removed its preference for small caps and downgraded tech stocks near the end of the summer, saying it believed that good news like strong earnings and tax-cut tailwinds had already been priced in.
Some believe the segment could still be reignited by renewed trade tensions — a scenario consistent with the International Monetary Fund’s (IMF) October downgrade of its global economic growth forecast due to risks like “rising trade barriers.” Analysts also believe that further divergence between the US economy and the rest of the world could help small caps recover.
“At the same time, economists are still relatively optimistic about the US, where data have shown the unemployment rate at multidecade lows, confidence among consumers and small businesses near records and corporate profits growing at a double-digit percentage pace,” the Journal said.