A so-called “flight-to-safety” trade into small capitalization shares in recent weeks continues to lift the performance of these companies’ shares versus large caps.
Since trade tensions between the U.S. and China began to boil over in early March, there’s been a rotation out of larger cap shares viewed as more exposed to any potential fallout from a trade war. Smaller companies also have less exposure to overseas revenues and derive a greater percentage of sales domestically. And as the dollar has strengthened in recent weeks, what had been a positive for large multinational companies – a weaker dollar – has faded.
“Several fundamental factors have driven small cap alpha in 2018,” said Alec Young, managing director, global markets research at FTSE Russell, in a recent blog post. “First, the Russell 2000 Index constituents’ 20% international revenue exposure is much lower than large caps’ overseas sales. Being more domestic helps small caps in several ways. Not only have they been less affected by geopolitical and trade fears, they’re also more leveraged to newly-enacted lower corporate tax rates and reduced Federal regulation.”
Since the start of the second quarter, the Russell 2000 has gained 2.1%, while the S&P 500 index is up by only 1.1% through April 23. And like the Nasdaq composite, which has risen by 3.3% since the beginning of the year, the Russell 2000 is still in positive territory, having gained 0.3%. Both the S&P 500 (down 0.1%) and the Dow Jones Industrial Average (down 1.1%) have yet to make up ground lost in February and March and remain in the red since the start of 2018.
The earnings growth story, which has been favorable for the broader market, is also another tailwind for small caps. FTSE Russell’s Young notes that “with Q1 earnings season off to a strong start, it’s worth remembering that small caps have a higher earnings growth outlook than large caps. Wall Street’s consensus 12-month forward earnings expectations for the Russell 2000 Index currently stand at 26% versus only 11% for the large cap Russell 1000 Index,” he said, citing data from Thomson Reuters as of April 17.
For Now, Defense, Oil and Banks…Concerns Ahead with Higher Rates?
Part of the trade into small caps has also been driven by investors playing defense while also seeking yield. Traditional dividend plays like utilities stocks gained 4.7% in March, among the best performing sectors within the Russell 2000 universe. Those stocks were yielding 2.63% during last month.
Higher oil prices along with booming domestic production of oil and gas led to a significant rebound in the Russell 2000’s oil & gas sector, which was up by more than 2.5%. Oil & gas producers gained 6.6% this past month.
For their part, financial stocks gained 1.9% during March and may be seen as an indicator for how the overall Russell 2000 performs in the coming weeks and months. Financials comprise 24.5% of the Russell 2000 and are packed with interest-rate sensitive stocks including regional banks and real estate investment trusts (REITs).
With the benchmark 10-year Treasury note headed past 3.00%, banks’ interest margins would generally benefit. However, the yield curve has been in a flattening trend in recent weeks. During the early part of the week of April 16, the difference between the two-year Treasury note and the 10-year Treasury note fell to about 43 basis points, its tightest point since 2007, meaning 10-year notes yielded just 0.43 percentage point more than two-year notes.
A flatter yield curve tends to pressure bank’s net interest margins and slow lending growth. The spread banks earn from their lending benefits when the difference between short- and long-term rates is greater since banks borrow short and lend long.
The Federal Reserve is also expected to continue to raise short-term rates throughout 2018. In general, small cap stocks carry higher debt loads than those of larger cap stocks, so could be more prone to higher interest rates. A portion of that debt is adjustable rate as well. And one of the downsides to tax reform passed in December 2017 was limits placed on the amount of debt companies can deduct.
A good portion, 34% of companies in the Russell 2000, also were losing money during 2017, according to an analysis in January 2018 by Barron’s republished here. So the Russell 2000 looks very expensive at a price-to-earnings ratio of 37.8 as of the end of the first quarter.
“Small-cap banks make up more than 20% of the Russell 2000 Index, so a flattening curve generally has a detrimental impact on those companies,” said Liz Ann Sonders, senior vice president and chief investment strategist at Charles Schwab & Co., in an April 23 commentary. “In addition, the aforementioned generally higher debt level of smaller companies means they’re dis-proportionally hurt by higher rates. Finally, weak credit fundamentals and higher equity market volatility are likely to amplify the impacts.”
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