US small-cap stocks break out, but for how long?

Long-lagging U.S. small-cap stocks are having a moment in the sun, but the interest rate outlook, the strength of their earnings and the health of the economy will help determine whether they are experiencing a new dawn or another false start.

The small-cap Russell 2000 surged 7% in August versus a nearly 2% rise for the S&P 500, the stock market benchmark. The Russell index dipped as September kicked off this week on a sour note for stocks, but its recent strength put it within about 4% of its November 2021 record closing high.

However, the S&P 500 is on pace to beat the Russell 2000’s annual performance for the 10th time in the past 12 years, a period that has seen the large-cap index more than double the gains of the small-cap gauge.

“They have underperformed relative to large caps for eons ... so you get to a point where the bar to clear is pretty darn low,” said Jordan Irving, a small-cap portfolio manager at Glenmede Investment Management.

Small caps are central to many strategies that would benefit from a broadening of stocks leading the rally. Investors in recent years have piled into huge technology and growth stocks, which have pushed equity indexes higher but raised worries that the bull market is too concentrated in megacap shares.

While tech is a dominant sector in the S&P 500, the Russell 2000 is more heavily influenced by areas such as financials and industrials that have lagged tech.

Critical to recent small-cap gains are growing expectations for Federal Reserve rate cuts because smaller companies are more reliant on debt financing and stand to benefit more from lower borrowing costs, investors said.

The Russell 2000 had its biggest one-day gain in more than four months on August 22, when Fed Chair Jerome Powell’s speech was interpreted as paving the way for an imminent cut. In the week after Powell’s remarks, BofA clients posted the second-largest weekly inflows into small-cap stocks and ETFs, the bank said, citing data going back to 2008.

While a rate cut is widely projected at the Fed meeting on September 16-17, the extent of further expected easing could sway small-cap performance, with employment data on Friday to test the rate outlook.

If more monetary easing occurs than is currently priced in, “that can be enough to unleash those discounted valuations and that pent-up demand for the small-cap asset class,” said Angelo Kourkafas, senior global investment strategist at Edward Jones.Ailing long-dated sovereign bonds around the world caught a break yesterday on a mix of soft U.S. jobs signals, decent auction buying and ebbing oil prices. The bond bounce and Federal Reserve easing speculation added to Alphabet’s near 10% surge on its antitrust win to lift Wall Street stocks again on Wednesday, with index futures up again ahead of Thursday’s bell. The day ahead brings another stream of labor market updates ahead of Friday’s critical August payrolls report.

* Fed futures rallied to fully price a quarter point interest rate cut later this month after news of falling U.S. job openings added to a downbeat readout from the central bank’s ‘Beige Book’ on economic conditions and relatively dovish soundings from Fed officials. Two-year Treasury yields hit a four-month low. The U.S. Senate Banking Committee will hold a hearing on Thursday to consider President Donald Trump’s nominee to the Fed board Stephen Miran while central bankers around the world fretted about potential threats to Fed independence.

* Long-dated government bond yields around the world pulled back from record or multi-year highs on Thursday in tandem with the 10 basis point slide in 30-year Treasuries from yesterday’s 5% peak, with Japan’s 30-year equivalent also getting a break after a bond sale there drew enough demand to calm the horses despite being the lowest bid-to-offer rate since June. UK 30-year gilts rallied too with a 20bp drop in yields from Wednesday’s highs. The dollar was firmer.

* Japan and the United States are in the final stages of talks to implement lower tariffs on Japanese automobile imports within 10-14 days after a U.S. presidential executive order. Japanese stocks rallied, but Chinese stocks sharply underperformed generally higher world stocks - falling the most in nearly five months after media reports of possible regulatory curbs on speculation.

Today’s column explores why the so-called ‘Fed put’ may not work for long-maturity bonds and why lower central bank rates could actually aggravate the problem.