Key Takeaways

• Small-cap stocks have outperformed their large-cap peers in recent days as investors have prepared for the Federal Reserve to begin making long-awaited interest rate cuts.

• Small caps are expected to benefit most from lower interest rates due to their propensity to hold floating-rate debt and have weaker balance sheets.

• Sluggish earnings and substantial uncertainty about the health of the U.S. economy are two reasons some expect small-caps to underperform in the near term despite lower rates.

While market participants are anything but certain about the specifics of the Federal Reserve's decision on interest rates rate tomorrow, there is one thing they know for sure: rates are about to come down.

That conviction has boosted small-cap stocks in recent days. The Russell 2000 index was up for the fifth consecutive session on Tuesday. The small-cap benchmark has risen more than 5% in those five days, putting it ahead of the large-cap S&P 500, which has advanced about 2.5%.

Small caps' outperformance comes as investors await the Federal Reserve's first interest rate cut in more than four years. The cut, due Wednesday, is expected to be the first in a series of reductions that Wall Street thinks will lower the benchmark federal funds rate by at least a full percentage point before the end of the year.

Why Are Rate Cuts Good for Small Caps?

Rate cuts are broadly supportive of stocks, as long as the economy isn’t in a recession. Small-cap stocks are thought to benefit more than their large-cap peers from monetary policy easing because they’re more likely to hold floating-rate debt. That assumption underpinned the small-cap rally that propelled the Russell 2000 more than 10% higher in July, its best month all year.

However, as analysts at Oxford Economics recently noted, small-cap performance has been mixed after previous interest rate cuts. At best, rate cuts have helped to moderate small caps’ underperformance relative to large caps in the late stages of tightening cycles.

Though, they say, this time could be different. Oxford expects small caps to be “outsized beneficiaries of the upcoming rate cuts…due to their relatively weak balance sheets.” Lower borrowing costs, easier financial conditions, and resilient consumer and business spending, they said, should alleviate some of small caps’ balance sheet pressure.

Economic Outlook, Sluggish Earnings a Concern

Others, however, advocate caution. Bank of America (BofA) on Monday said its "Regime Indicator," a measure of market sentiment, declined for a second consecutive month in August, indicating a general risk aversion in markets. Small-cap stocks, due to their sensitivity to economic conditions and typically weaker balance sheets, are often riskier investments than comparable large caps.

Quarterly earnings are also, according to BofA analysts, an overhang for small caps. The small-cap S&P 600, they note, may have exceeded second-quarter earnings expectations, but the group’s aggregate profits still declined 10% from a year ago. Total sales also missed estimates and the outlook for the remainder of the year was bleaker than previously forecast. That, they said, could limit near-term upside from this week’s rate cut.

Some See Better Opportunities in Mid Caps

BofA analysts instead recommended mid-cap stocks as a near-term hedge against market weakness. Mid caps, they said, offered better second-half earnings guidance than small caps, and tend to outperform small and large caps in the year after rate cuts.

Analysts at Goldman Sachs were similarly bullish on mid caps in a note last week. The group offered investors, they wrote, "superior earnings growth at a reasonable price compared with large-caps," and stronger income statements and balance sheets than small caps.

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