It was a quiet week for economic data leaving the markets to focus on corporate earnings and Federal Reserve rhetoric. Just a week after the last Federal Reserve FOMC meeting where officials decided to hold interest rates, Chair Jerome Powell spoke at an International Monetary Fund event in Washington DC that threw cold water on recent optimism that the central bank was done with its hiking cycle. The statement that drew most attention was Powell’s comments about inflation – “The FOMC is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2 percent over time; we are not confident that we have achieved such a stance.” Other Fed officials noted that the full effects of policy tightening have yet to filter through the economy meaning there could be more pain to come without additional hikes. Whether the Fed raises interest rates to combat sticky inflation remains to be seen, but the message to Wall Street was clear – investors should not put on their rose-tinted glasses just yet. Following Powell’s comments, as well as the consumer sentiment report on Friday, yields rose in the 2–10-year range of the curve, pushing fixed income as measured by the US Aggregate index down -0.3% for the week. The S&P 500 posted a Friday rally to end the week higher by +1.4%, but of note, the more rate sensitive Russell 2000 small cap index ended the week lower by -3.1%.
While corporate quarterly reports continue to look solid for large companies, smaller companies are having a greater challenge maintaining sales, earnings, and margin growth amid wider economic pressures. With 90% of small cap companies reported for Q3, the Russell 2000 looks set to lock in a third quarter of sales declines in the last four. Small cap stocks are generally more sensitive to yields, credit developments, and cyclical economic activity compared to large cap peers. The “higher for longer” positioning from the Fed has clearly been weighing on small companies with the index lower by nearly -2% in 2023 and valuations moving closer to cycle lows.
Many large cap companies were able to lock-in low interest rates in the COVID period; however, small caps were generally not able to term out their fixed rate debt as far into the future. As such, small caps face a greater maturity wall – or when debt comes due and likely needs to be re-financed – in the near-term. Most maturing debt was issued at lower interest rates in the post-GFC period, and any re-financing activity is highly likely to increase interest expense putting greater pressure on profit margins. Another pressure point is the Russell 2000 holds nearly 30% of its debt in floating rate instruments (vs. 6% of the S&P 500). The rising interest rate environment has already been pinching financing costs and, in combination with the upcoming maturity wall, will subject small cap companies to greater default risk.
That is if small caps can re-finance at all… banks (and investors) have been raising their lending standards amid weakening economic outlooks.
On Friday, University of Michigan released sentiment survey figures showing the consumer continues to lose confidence in their own buying power and the economy more broadly. The index slid to a six-month low following persistently higher prices, increased borrowing costs, and a slowing labor market. Consumer sentiment generally ties into spending which has remained robust to this point, but the loss of confidence may slow spending leading into a holiday season. Included with the survey report, consumers expect prices will rise at an annual rate of +3.2% over the next 5-10 years, up from +3.0% a month earlier and increasing to the highest level since 2011. Additionally, they see costs rising +4.4% over the next year, compared to +4.2% the previous month. Entrenched inflation expectations especially above the Fed’s long-term target of 2% will give FOMC officials something to think about ahead of their December meeting.
Source: Bloomberg, Federal Reserve, University of Michigan
– Written by Eric Schmitz, CFA