Small caps, big potential

by Denise Chisholm, Director of Quantitative Market Strategy

Interest rate cuts look increasingly likely, as the U.S. Federal Reserve (the Fed) weighs concerns about the U.S. economy and declines in inflation. As part of my work analyzing past trends in search of insights for today’s investors, I recently explored which parts of the market might benefit the most from lower interest rates. Small caps have been a prime beneficiary, historically—especially when their valuations were as low as they have been recently.

Rate cuts have supported small caps The Fed seems highly likely to cut interest rates later this year, and not just because worries about the economy have grown in recent weeks. The Fed’s preferred inflation gauge, the Personal Consumer Expenditures deflator (PCE), fell to 2.5% as of June, in the bottom half of its historical range. At the same time, the federal funds rate was in the top quartile of its range. Going back to 1954, the Fed cut interest rates within the next 12 months more than 75% of the time when PCE and the fed funds rate reached the same ranges. And after the first rate cut of a cycle, small caps outperformed the S&P 500 over the next 12 months 70% of the time (Exhibit 1), with an average outperformance of more than 5%.

Small caps look undervalued relative to large caps

Small caps’ low valuations relative to large caps also point to potential leadership, based on history. ... Continue reading