Opportunities for small caps in a changing economic climate

06/25/2024 — Key takeaways:

• A potential rate cut could serve as a catalyst for small-cap stocks—offering potential for growth into 2025.
• This may be an opportunity for investors to diversify or rebalance portfolios following significant appreciation of large-cap holdings.
• 4 catalysts exist that are likely to create a favorable climate for investing in small-cap stocks

In recent financial markets news, you may have noticed that small-cap stocks have taken a bit of a backseat to their large-cap counterparts, particularly the “Magnificent 7” large-cap stocks which have dominated the news cycle given their performance as of late.

In fact, while the S&P 500® Index recorded nearly two dozen all-time highs for the year-to-date during the early part of 2024, the S&P SmallCap 600® Index got off to a slow start over that same stretch.

Good news for long-term investors

By the end of April 2024, the S&P SmallCap 600 was trading at an approximate 30% discount to the S&P 500. As a result of this attractive valuation, small caps offer long-term investors some potential opportunities for growth—especially those investors seeking to diversify or rebalance their portfolios following significant appreciation of their large-cap holdings.

And, given their historical track record of delivering strong absolute and relative performance through multiple market cycles, small-cap stocks may be worth an even closer look.

This all spells good news for long-term investors, despite the ever-changing outlook for monetary policy easing and inflation, which both present inherent risks for smaller companies. However, thanks to the continued resilience of the U.S. economy, fears of economic recession are being tempered and we should expect to see above-trend growth as a result, which is favorable for those same smaller companies.

Why is this climate favorable for small-cap investments?

From our viewpoint, there are four different catalysts emerging in the current market cycle that are likely to create a favorable climate for investing in small-cap stocks.

1. We see an encouraging outlook for profits in the days, weeks, and months ahead. If the U.S. economy avoids a recession in 2024, a range of variables is in place that may lend itself to good performance for small-cap stocks.
2. We anticipate continuing momentum for recovery. Small companies are usually more sensitive to changes in economic conditions than large companies. That said, sentiment for small businesses is moving in the right direction, albeit very modestly.
3. The third catalyst we’re seeing emerge in the current market cycle is business cycle rotation. With inflation appearing to stay persistent, higher-for-longer interest rates will remain a risk for smaller companies and therefore small-cap stocks. A modest allocation to small caps can potentially enhance portfolio diversification and may boost returns, but investors should weigh the risks.
4. And finally, the eventual start of rate cuts could also prove beneficial for smaller companies. Although the timing and size of any future rate cuts by the Feds are uncertain as of this writing, in general, a looser monetary policy has historically benefited small caps more so than their larger peers. This may be especially true in the current small-cap climate, where more firms are dependent on floating-rate debt and should see their interest expenses fall as interest rates ebb.

All that to say, recent developments with weakening economic data have led many to believe that a potential rate cut is on the horizon, which would serve as a catalyst for small-cap stocks—offering long-term investors a greater potential for growth in the latter half of the year and into 2025.