No Solace in Small Caps

In the U.S., second-quarter earnings season has generally been better than expected. However, it has failed to inspire investors. While low rates and sluggish wage growth have allowed profit margins to remain at record levels, large U.S. companies continue to struggle with the competitive headwind caused by a stronger dollar, which has hurt revenues and estimates of third quarter earnings.

In an effort to mitigate the impact of a stronger dollar, many investors have been favoring small-cap stocks, which depend less on international sales than larger companies. But the strategy hasn’t provided much benefit so far this year. The large-cap S&P 500’s modest 1% gain is slightly ahead of the small-cap Russell 2000’s performance year-to-date, according to Bloomberg data.

What exactly is holding back small caps? As I write in my new weekly commentary, “The Curious Case of Dollar Strength,” while small caps do have less exposure to international sales, they have proved more vulnerable to rising real interest rates (the interest rate after inflation) and investor anticipation of monetary tightening.

Recent U.S. economic data—including the ISM non-manufacturing survey and the July non-farm payroll report—have provided more evidence that the economy in the second half of the year should show an improvement over what we saw in the first half. As such, there’s a growing perception that the economy is strong enough for the Federal Reserve (Fed) to begin removing the ultra-accommodating conditions that have defined U.S. monetary policy since 2008, and many market watchers expect the Fed to start raising interest rates this fall.

Those expectations are leading to what’s known as a flattening of the yield curve, whereby shorter-term bond yields rise faster than yields on longer-term bonds, as the former sell off. And this, in turn, helps to explain small cap’s lackluster performance. During earnings season, investors worried about the impact of a flattening yield curve on small cap banks, which make up roughly 25 percent of the Russell 2000, according to Bloomberg data. In addition, consistent with history small cap earnings multiples are proving more vulnerable to a tightening in monetary conditions. According to the Bloomberg data, in July, the trailing price-to-earnings ratio for the Russell 2000 contracted by roughly 2 percent, while S&P 500 gains were supported by multiple expansion of roughly 2 percent.

As for what this means for investors looking forward, I continue to remain neutral in terms of any size bias in U.S. equities. Though small caps have lower exposure to the dollar’s impact on international sales, this benefit is being trumped by small cap’s potential vulnerability to the changing interest rate environment.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

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