Federal Reserve’s pivot to a potential rate cut likely to fire up small cap investors

A trader work on the floor of the New York Stock Exchange. Picture: AFP

This week’s dovish turn in the US Federal Reserve’s policy rhetoric has sparked a wave of optimism for rate cuts among market participants, particularly small-cap ­investors.

And to my mind the enthusiasm is justifiable. The Fed’s surprising pivot towards a potential rate cut of 0.75 percentage points next year realistically sets the stage for a meaningful rally in the most dynamic subsector of the sharemarket.

Many small-cap stocks, typically defined as companies with a market capitalisation of between $300m and $2bn, are known for their high growth potential. These businesses are often in the early, middle and accelerating stages of their growth cycles and are poised to benefit substantially from both favourable economic conditions and more sanguine sentiment towards risk.

Lower interest rates, a key tool for stimulating economic growth, is particularly beneficial, as is their impact on present values.

A year ago, in November 2022, and after interest rates had been raised at an unprecedented rate, I noted that 2023 should be a good one for innovative growth stocks with pricing power.

The prediction was based on the combination of disinflation and positive economic growth, which historically has been supportive for such companies.

The prediction was only partly right however, because the strong gains were confined to those so-called “Magnificent Seven” mega-cap technology companies you’ve now heard so much about. And while those seven companies are indeed innovative, with many leveraging extraordinary pricing power (Tesla arguably being the exception), it seems the rest of the “innovative” universe was left ­behind.

Many innovative growth companies with pricing power reside in the small cap part of the market. And provided we aren’t plunged into a deep recession – a scenario I believe has only a very small probability of occurring – I believe the US Federal Reserve has now set the stage for a “catch-up” of these companies in 2024.

Furthermore, the cost of borrowing can be a crucial factor for small businesses. When the Federal Reserve cuts rates, it signals a more accommodative business environment while effectively (eventually) lowering the interest expense for companies borrowing to fund their operations or expansion. This reduction in costs simultaneously leads to increased profitability and provides more capital for investment in new projects, technology and workforce expansion. Additionally, lower rates alleviate the cost-of-living pressures experienced by many consumers, leading to increased consumer spending, which directly benefits retailers and other domestically focused businesses. These shifts are all particularly advantageous for small caps, which are more sensitive to economic changes and have the ability to manoeuvre more swiftly compared to their larger counterparts.

A US rate cut would light the fuse on small caps.

The backdrop for this optimistic outlook is the Fed’s acknowledgment of declining inflation rates. The central bank’s statements and projections this week suggest a cooling of inflationary pressures, leading to a surge in Treasury bond prices and a notable decrease in the yield on the 10-year Treasury.

Some investors understandably remain apprehensive. They point to the slowing economy and the risk of a recession. While I am unwilling to predict whether we will have a recession or not, I do believe the probability of a technical recession – two quarters of negative economic growth – is a more likely scenario than the sort of deep recession that plunged businesses into bankruptcy in the early 1990s, resulting in unemployment surging towards 11 per cent. And with wage growth and inflation slowing down, the US economy is showing signs of more balanced growth. Meanwhile, the labour market remains robust, with unemployment rates dropping and steady job additions, albeit at a slower pace than before.

Small-cap stocks often flourish in post-recessionary periods or during recoveries from economic slowdowns. Remember smaller companies, due to their agility, can adapt quickly to changing economic conditions, seize new opportunities, and grow their market share, thereby capitalising on economic recoveries. As the economy moves away from the shadow of higher inflation and interest rates, I believe small caps are likely to be at the forefront of the stockmarket recovery.

Finally let’s not forget valuations. While each company needs to be valued independently, the price earnings ratio for the S&P 600 Small Cap Index is at 13.2, only marginally above the lowest levels it has reached since the beginning of the new century. That’s a big deal. The last three periods the PE was this low we saw either rates and inflation surge, or the recessions of the GFC and pandemic.

Not only is the economic and interest rates outlook, and hence small-cap prosects, looking better, but small caps are historically cheap. I expect companies with thematic tailwinds will benefit first from an improvement in sentiment towards smaller companies.

Data centre operators and their ancillary service providers, retailers growing a global store footprint and businesses enjoying growth of a structural nature – think communications – could have a very good year in 2024.

Roger Montgomery is founder and chief investment officer at Montgomery Investment Management