High interest rates suppress the rebound market, leading to potential differentiation in U.S. small-cap stocks, with profitable small-cap stocks expected to perform better
The rebound of small-cap stocks in the US stock market has ended, as high interest rates raise concerns among investors. Although the Russell 2000 index rose by 7% in August, it has been declining continuously since September. Analysts are focusing on profitable small-cap stocks, believing they perform better in uncertain environments. The high-yield bond market is sensitive to borrowing costs, and profitable small-cap stocks can generate cash flow, making them less affected by high interest rates. Data shows that since December of last year, profitable small-cap stocks have outperformed unprofitable small-cap stocks when the 10-year US Treasury yield rose to 4.6%
According to the Zhitong Finance APP, the rebound of small-cap stocks in the US stock market has come to an end, as investors are concerned that the pace and extent of interest rate cuts are insufficient to support heavily indebted companies. Data shows that the Russell 2000 Index rose 7% in August, marking the best monthly performance of the year, but has declined on every trading day since entering September.
The uncertainty that the yield on 30-year US Treasury bonds may break 5% has dampened the popularity of small-cap stocks, as this means that bond market rates will remain high regardless of the Federal Reserve's actions. At the same time, due to the uncertainty of the US economic outlook, the market is also worried that even if the Federal Reserve relaxes its policy this month, it may again enter a wait-and-see mode.
Overall, these factors have left traders lacking reasons to make large bets on small-cap stocks, even though small-cap stocks are generally seen as one of the asset classes that benefit the most from interest rate cuts. Instead, analysts are examining companies in this sector one by one and betting on those that can still maintain profitability in uncertain environments.
Dennis Debusschere, Chief Market Strategist at 22V Research, stated, "When the yield on 10-year US Treasury bonds rises, loss-making small-cap stocks are under particularly significant pressure," adding, "In contrast, profitable small-cap stocks can generate internal cash flow, and their recent earnings streams are less sensitive to higher interest rates."
It is reported that companies in the Russell 2000 Index often finance in the high-yield bond market, which is particularly sensitive to changes in borrowing costs. While lower interest rates may provide support for these companies, the ones most likely to benefit are those with the strongest fundamentals.
According to data compiled by the media, since December of last year, whenever the yield on 10-year US Treasury bonds rises to or exceeds 4.6%—a level considered important by some stock market observers—profitable small-cap stocks have outperformed loss-making small-cap stocks. In May of this year, when the yield on 10-year US Treasury bonds rose from a short-term low to 4.6%, the former outperformed the latter by 4.6 percentage points.
Joe Mazzola, Head of Trading and Derivatives Strategy at Charles Schwab, stated, "40% of the companies in the Russell 2000 Index are essentially operating at a loss." "These companies really need the yield curve—or at least long-term yields—to behave more moderately."
Of course, not all loss-making small-cap stocks are the same. Dan Boston, Head of Global Small Cap at Polar Capital and Fund Manager, urged investors to distinguish between companies that are not yet profitable due to growth investments and those with shallow business models and a lack of profitability Dan Boston believes that if interest rate cuts are imminent, growth-oriented small-cap stocks will become relative winners in the sector, while value-oriented small-cap stocks may lag behind. This will contrast with the current situation this year—according to Bank of America statistics, value companies in the Russell 2000 index have outperformed growth companies by 2.5% this year. He stated, "Some companies are making money, while others are not. They are not only different but worlds apart."
