Fed Rate Cuts Often Ignite Small-Cap Outperformance
Fed rate cuts have often acted as a catalyst for small-cap outperformance, with this segment frequently outperforming large-caps over the next 3, 6, and 12 months. Coupled with cheap valuations, accelerating M&A activity, and improving earnings, we are optimistic that the recent trend of small-caps outperforming large-caps can continue. Additionally, tight high-yield spreads and a steeper yield curve further support this outlook.
- Risk Appetite: Lower interest rates generally reduce borrowing costs and can stimulate economic growth, boosting investor confidence and increasing risk appetite. Currently, small-cap stocks are historically under-owned and undervalued. As risk appetite improves and the discount for small-cap stocks narrows, this should drive a reversion to the mean in terms of both performance and positioning
- Liquidity and Access to Capital: Lower interest rates improve market liquidity and make it easier for smaller companies to access capital. As small-cap firms rely more heavily on external financing compared to larger companies, this can lead to improved performance. The small-cap sector has been particularly sensitive to refinancing risk during the Fed’s rate-hiking cycle, and we expect this risk to diminish significantly during the easing cycle.
3. Cyclical Sensitivity: During Fed easing cycles where employment deteriorates sharply (e.g., during a recession), market selloffs often occur as unemployment claims rise. Small-cap stocks, being more sensitive to economic cycles, tend to experience more pronounced performance differentials under these conditions.
In summary, small-cap stocks historically perform well following Fed rate cuts, especially when the cuts are aimed at stimulating economic growth. We see no reason to believe this time will be different.
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