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Many equity strategists entered the year eager for a recovery in small cap performance as the consensus believed the Federal Reserve would start cutting rates in the first half of 2024. As the market scales back hopes for rate cuts this year, the small-cap Russell 2000 Index (^RUT) is down nearly 3% this year, underperforming compared to the S&P 500’s more than 5% gain this year.

“We think the Russell 2000 could be tested a bit in the near term until we get more confirmation of the slowdown in inflation and more confirmation that the Fed will be able to start cutting rates,” according to Bank of America. of US small and mid-cap strategy Jill Carey Hall to Yahoo Finance.

After recent calls with investors, Hall said the main catalyst for small caps’ rise is more clarity on the Federal Reserve’s interest rate path.

According to data from Bloomberg, the market consensus has shifted from seven rate cuts this year in early January to two rate cuts this year. This move has put a significant damper on the small cap rally through the end of 2023, while large cap stocks have still held on to their gains this year despite the Fed’s shifting narrative.

The main difference is the debt structure of the companies. Small caps have over 40% of their debt exposed to higher interest rates, either in the form of variable rate loans, which are exposed to current interest rates, or in the form of short-term debt that may need to be refinanced in light of the higher interest rates. This compares to the roughly 75% of S&P 500s that have fixed, long-term debt, according to Bank of America’s research team.

Add to that the fact that large-cap companies often have more cash that could benefit from higher interest rates, and the Fed not cutting rates is simply more expensive for smaller companies than for larger companies.

“The (Russell 2000) index is very sensitive to credit and interest rates,” Hall said. “Refinancing risk is a key risk for these companies as large caps have been able to hold a lot of long-term, fixed-rate debt… longer term rates remain high, which is becoming an increasing risk to earnings for these companies (smaller cap-caps) companies.”

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