While it was a relatively quiet week on the macro front, last week was marked by more earnings announcements and a handful of notable statements from Federal Reserve Governors. Fed members throughout the week continued to reiterate a hawkish tone, emphasizing the importance of closely monitoring inflation pressures and acknowledging that the full impact of tightened policy has yet to materialize. Given that many companies were able to lock in ultra-low interest rates for long periods, the typical lagged effect of monetary policy was pulled even longer. As new refinancing activity occurs, larger interest expense should start to negatively impact corporate earnings, particularly for lower-cap companies. All told, equity markets (as measured by the S&P 500 Index) finished the week 1.9% higher, while the US Aggregate Bond Index traded up 0.1%.
Refinancing Risk: Small Caps Have Larger Share of Debt Due in Next Five Years
Share of Debt Maturities: Russell 2000 Index vs S&P 500 Index
Source: Bloomberg, S&P, Russell. As of May 10, 2024
The lagged effects of the tighter monetary environment are most noticeable down the market cap spectrum. Russell 2000 small cap companies hold a total of $832 billion in debt, of which 75% ($620 billion) needs to be refinanced through 2029. For comparison, companies in the large cap S&P 500 Index have just 50% of debt due by then. As such, small cap companies are trading at a meaningful discount to large cap counterparts—particularly with the risk of a cyclical economic slowdown.
Small-Cap Valuations Are Historically Low
Price to Sales: Russell 2000 Index vs S&P 500 Index
Source: Bloomberg, S&P, Russell. As of May 10, 2024
Speaking of earnings season, Q1 is coming to a close with 91% of S&P 500 companies now reported, although a few notable stragglers—namely Nvidia, Home Depot, and Walmart—will be reporting in the coming weeks. The corporate sector remains healthy, with earnings growing at a 7.1% annualized rate. Still, management teams have indicated a difficult operating environment is expected going forward. Analyst expectations suggest the Magnificent Seven stocks will slow its revenue and earnings growth while the rest of the S&P accelerates through 2024. Right now, the earnings growth story remains intact, but there are notable risks on the horizon.
– Written by Eric Schmitz, CFA