Small-cap stocks experience heightened volatility amid uncertainty over interest rates
Small-cap stocks in the US have recently experienced a significant increase in volatility, reflecting their dependence on interest rates. The year started off on a lackluster note for small-cap stocks, but this was quickly followed by a surge in volatility triggered by uncertainty surrounding the Federal Reserve's decision on interest rates. This uncertainty has been fueled by mixed inflation data in January. The Russell 2000 index, which tracks small-cap stocks, has witnessed its most prolonged movement streak since March 2023, indicating a period of heightened activity in the market.
The recent performance of the Russell 2000 index has also revealed the strong influence of Federal Reserve policies and interest rate expectations on small-cap stocks. In fact, the Russell 2000 outperformed other major indexes last week, suggesting that small caps are significantly impacted by changes in interest rates.
Investors typically expect small-cap stocks to underperform when there's a sentiment that interest rates will remain high for an extended period. Conversely, they tend to recover when there are signals that the monetary-tightening cycle might conclude.
The situation became even more volatile across US stocks when a January inflation report exceeded expectations, resulting in the worst day for the Russell 2000 index since June 2022. However, the market mood improved following dovish comments from a Federal Reserve official and a disappointing retail-sales report. These factors ignited hopes for a possible interest rate cut in the coming months.
While some investors initially anticipated a substantial resurgence in small-cap stocks this year, encouraged by their brief outperformance in December and prospects of decreasing interest rates, the Russell 2000 has only shown modest gains compared to larger indexes such as the S&P 500 and Nasdaq. This reflects the hesitancy among investors about the economy's direction towards a soft landing.
Analysts are optimistic that small-cap stocks may soon catch up to their larger-cap counterparts. Historically, negative correlations between interest rates and small caps have been short-lived. However, the recent rise in rates has not led to the expected outperformance of small-cap stocks due to unconvincing earnings growth.
The volatility observed in the Russell 2000 index suggests that investors are skeptical about the smoothness of the economic transition. Recent movements in small-cap stocks are seen more as a speculative diversification rather than a result of confidence in small caps driven by favorable economic conditions or looser credit.
It is worth noting that the performance of small-cap stocks is closely tied to the overall economic health and borrowing conditions. This poses challenges for unprofitable companies within the sector.
Analyst comment
Neutral news. The market for small-cap stocks is expected to remain volatile due to uncertainty surrounding interest rate adjustments and mixed economic data. Investors are cautious about the direction of the economy and hesitant to fully embrace small-cap stocks until there is convincing earnings growth and a smoother economic transition. Small caps may catch up to large caps in the future, but challenges remain for unprofitable companies in the sector.
