Looking at the macroeconomic picture for US small caps, these firms are usually more in tune with the domestic economy: typically, when interest rates rise, the economy is doing better – and that is an environment where US small caps can (and should) do better.
And after years of an extremely low-interest-rate environment, the US Federal Reserve has been making incremental adjustments upward to the Fed funds rate, setting the stage for rising interest rates for borrowing and – hopefully – investing.
When the central bank raised the rate from 1 percent to 1.25 percent in June, the Fed said in a statement: ‘Information received since the Federal Open Market Committee met in May indicates that the labor market has continued to strengthen and that economic activity has been rising moderately so far this year.’
For small caps this is a positive path going forward, but the final destination is less certain. ‘This is likely to be a multi-year process toward a peak rate no one can predict at this point,’ says Fred Buonocore, senior vice president of the Equity Group, an investor relations firm in New York.
This has many implications for public companies, which will be more pronounced for small caps because a higher cost of capital has limited both returns and borrowing options for them compared with larger corporations. ‘During periods of rising interest rates, small-cap stocks tend to outperform their larger-cap brethren,’ notes Jeff Stanlis, a partner at IR consulting firm Hayden Investor Relations.
Buonocore adds: ‘A major consideration for companies fortunate enough to have built up a cash reserve will be whether or not to tap their ‘dry powder’ when making acquisitions or capital investments, when in the past several years using leverage to enhance returns was a no-brainer.’
And as US small-cap companies tend to be more US-centric, they are less exposed to the gyrations of the dollar and other aspects of global volatility that are more likely to affect large multinational organizations.
‘The Fed has made it clear that rates are on the rise,’ says Stanlis. ‘By how much and how fast is still anybody’s guess, though recent dovish commentary has injected new euphoria into the markets. As long as there are no shocks to the currently anticipated slow and steady maneuverings of the Fed, the gradual reflation trend should continue to benefit small-cap issuers.’
Beyond borrowing costs, higher rates will have an even greater long-term impact on specific sectors, particularly banking and insurance. For the past few years, many financial institutions have achieved moderate returns on their existing investment portfolio in a retracted interest rate market.
A rising-rate environment is particularly important for small caps due to the relative gains from each incremental 25 basis-point improvement. ‘IR professionals need to have a keen understanding of the impact the higher-rate trend is having – and will have – from both the economic/earnings-related front and the management decision-making aspect of their company,’ notes Buonocore.
Constrained labor market
Also on the macroeconomic front, though less talked about in mainstream financial media than interest rate hikes, are the challenges presented by a stronger labor market.
Companies whose operations depend on large numbers of skilled and unskilled laborers, such as construction and manufacturing organizations, are increasingly feeling the effects of higher demand for workers resulting from a US economy that is showing real signs of health and potential for meaningful growth.
‘The stronger demand translates into both higher cost and greater mobility for workers,’ explains Buonocore. ‘For small-cap companies, the impact of rising costs of goods sold and increased employee turnover caused by labor moving to higher-paying greener pastures can have an outsized impact on revenue and profitability.
‘IR professionals need to have an in-depth understanding of how this dynamic is at play within the organizations and be able to explain and quantify the impacts and outlook to the investment community.’
Click here to read part one in the series, From politics to regulation and Europe: US small-cap challenges.
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