Small-Cap Stocks Face Heightened Risk as Rate Cuts Hinge on Inflation

Small-cap stocks, once the darlings of the market, are now facing a new challenge as the Federal Reserve's rate-cutting cycle appears to be on hold, warns Bank of America (BofA). The Russell 2000 index, a broad gauge of small-cap equities in the U.S., has slumped into correction territory, with investors continuing to dump them after the index ended Friday in correction territory.

The Russell 2000 index RUT, a broad gauge of small-cap equities in the U.S., was slumping 0.3% Monday afternoon for a year-to-date drop of 2.2%, according to FactSet data, at last check. The index's sharp fall Friday landed it in correction territory, with a correction defined as a 10% drop from a recent peak, according to Dow Jones Market Data.

"Refinancing risk is back" for small-cap stocks, said equity and quantitative strategists at BofA Global Research, in a note dated Jan. 12. They said BofA economists now think the Federal Reserve's rate-cutting cycle is over, a view expressed after Friday's stronger-than-expected U.S. jobs report for December and as inflation remains stuck above the Fed's 2% target.

The strong U.S. jobs report "underscores our caution on the Russell 2000," with its performance appearing "highly tethered" to market expectations for the Fed's future rate path, the BofA equity strategists wrote. They also said that the recent climb of the 10-year Treasury bond yield BX:TMUBMUSD10Y has hurt small-cap stocks.

Small caps' relative performance correlation with the yield on the 10-year Treasury note is "the most negative in our data history" - and its rate has continued to rise, the strategists said. Treasury yields are rising against the backdrop of a resilient U.S. economy.

The yield on the 10-year Treasury note has leapt higher since the Fed began its rate-cutting cycle in September. On Monday, the 10-year rate was up about 2 basis points in afternoon trading at around 4.78%, according to FactSet data, at last check.

"While a resilient macroeconomy is positive for small caps," the BofA strategists said that "the Fed was one of the biggest drivers" of selloffs and rallies in the Russell 2000 in the past year.

Small-cap stocks underperformed in the first half of 2024 on stickier-than-expected inflation measured by the consumer-price index, according to their note. They "then rallied dramatically in July on confidence in the start of a cutting cycle amid easing inflation" before, more recently, the Fed's "hawkish" policy meeting in December helped spur the Russell 2000's "worst relative month vs. large caps" since 1998, the strategists said.

Small-caps stocks have historically outperformed in the 12 months following the Fed's final rate cut, as well as overall in the period between its last cut and first hike - but unlike this time around, most rate-cutting cycles have happened around recessions, according to BofA.

Small-cap stocks would go from "bust" to "boom" as the economy moved into a recovery mode following an economic recession, the strategists said. When the Fed cuts rates to help the economy recover from recession, small caps stand to benefit from lower borrowing costs.

The Fed started its cutting cycle in September as it moved to recalibrate its rate policy following a substantial easing in the rate of inflation even as the U.S. economy continued to expand.

With the Fed's rate-cutting cycle now appearing on pause - or maybe even done - small-cap stocks face heightened refinancing risk while "still struggling to emerge from their profit recession," according to the BofA note.

"Within small caps, we would continue to tilt toward economically sensitive stocks with low refinancing risk," focusing on "higher-quality stocks with positive earnings and revisions," the strategists said. "At the sector level, financials screens best in our work within both small- and midcaps."

The BofA strategists said they prefer midcap stocks to small-cap equities. "We continue to see better opportunity in midcaps," they wrote, explaining they have "cleaner balance sheets," less rate risk and less policy risk following the election of Donald Trump as president of the U.S.

Small-cap stocks are struggling after initially rallying after President-elect Trump won the race for White House.

The Russell 2000 index ended Friday 3.2% below its closing level on U.S. Election Day on Nov. 5, according to Dow Jones Market Data. The Russell 2000 closed Friday down 10.4% from its recent closing high notched Nov. 25, finishing the week in correction territory, according to Dow Jones Market Data.

On Monday, the Russell 1000 RUI, which tracks an index of larger U.S. companies, was down 0.2% in afternoon trading, faring better than the small-cap-focused Russell 2000 index.

The U.S. stock market was trading mostly down Monday afternoon, with the S&P 500 SPX slipping 0.1%, the technology-heavy COMP Nasdaq Composite falling 0.7% and the Dow Jones Industrial Average DJIA rebounding 0.7%, according to FactSet data, at last check.



In conclusion, small-cap stocks face heightened risk as the Federal Reserve's rate-cutting cycle appears to be on hold, with investors continuing to dump them after the Russell 2000 ended Friday in correction territory. The strong U.S. jobs report and rising Treasury yields have exacerbated concerns about refinancing risk for small-cap companies, which often hold variable-rate debt and have weaker balance sheets. While mid-cap stocks may offer a better opportunity, investors should remain vigilant about the potential challenges posed by trade tariffs and geopolitical tensions. As always, thorough research and careful consideration of individual company fundamentals are essential for making informed investment decisions in the small-cap space.