Small-cap stocks and category-related ETF that previously strengthened on the escalating global trade spate are now underperforming on the recent trade agreements, and the asset category may also come under pressure as the monetary policy tightens ahead.
The iShares Russell 2000 ETF (NYSEArca: IWM) fell 8.3% over the past three months, compared to the -0.6% pullback in the S&P 500.
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.
Furthermore, some are now concerned that the Federal Reserve’s tighter monetary policy could pressure the broader equity market.
“Fiscal stimulus is still out there and we’re still going to have one or two quarters where that helps earnings, but it’s waning, and it’s definitely not going to stay for a long time,” Omar Aguilar, chief investment officer for equities and multiasset strategies at Charles Schwab Investment Management, told the Wall Street Journal.
Small-cap rally vulnerable?
For the past few months, analysts at Morgan Stanley, Bank of America Merrill Lynch and PIMCO warned that the small-cap rally appeared vulnerable. Market observers warned that small caps often struggled as an economic expansions neared their end, especially since they are hampered by rising wages and borrowing costs, which may be particularly likely in the years ahead.
Bank of America Merrill Lynch analysts also warned that small-cap’s are now highly leveraged and rely on a smooth economic environment. Excluding financial companies, the Russell 2000 Index’s corporate debt was roughly 3.5 times earnings before interest, taxes, depreciation and amortization, or close to all-time highs hit in the early 2000s and above the 1.8 times EBITDA ratio for the S&P 500.
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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