For a good part of 2018, small-cap stocks and the related exchange traded funds were a popular trade as some market observers opined that the strong dollar and rising interest rates would not weigh on smaller companies.
Due to the domestic focus of small-cap companies, it was also believed these stocks would be less vulnerable to global trade spats, but recent price action in the group suggests otherwise.
Small-capitalization stocks have attracted a lot of attention on the escalating trade tensions, fueled by fears over a potential slowdown in global growth. Consequently, many anticipated that small-caps could weather the storm as large multi-nationals with a large global footprint suffered from trade disputes. However, the U.S.’s recent trade agreements with Canada, Mexico and the European Union have reversed the play.
In recent weeks, one of the best-performing small-cap ETFs has been the Direxion Daily Small Cap Bear 3X Shares (NYSEArca: TZA). TZA attempts to deliver triple the daily inverse performance of the Russell 2000 Index.
Rates Not Cooperating
While small-caps were seen as one of the places to be as the Federal Reserve boosts interest rates, that trade is eroding.
“Rising interest rates are problematic for smaller firms because they tend to have a much higher proportion of debt tied to a floating interest rate than larger companies do, and more debt in general. As rates climb, so will the interest on loans that small businesses carry,” reports The New York Times.
Data suggest the recent rise in interest rates is plaguing smaller stocks.
“Since late August, when small caps peaked, interest rates have marched higher. The yield on the 10-year Treasury note climbed to nearly 3.25 percent earlier this month from less than 3 percent. And the Federal Reserve — which exerts control over short-term interest rates — has signaled that it plans to stick to its plans to keep raising rates in the face of strong economic conditions,” according to the Times.
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Consequently, in a rising rate environment, it will become harder for small-caps to borrow and repay debt. Leverage is “one of the biggest risks” small caps face over the medium term, Jill Carey Hall, U.S. equity strategist at Bank of America Merrill Lynch, told the WSJ.
Looking ahead, it will be hard to find additional reasons for small-caps to outperform large-caps as strong earnings and tax reforms have already been priced into the market, according to Morgan Stanley analysts.
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