Huge debt is on the top, and US small-cap stocks have become the most dangerous stocks in the market?
Companies in the small-cap Russell 2000 hold a total of $832 billion in debt, 75% of which ($624 billion) will need to be refinanced by 2029, according to data compiled by Bloomberg.
While small-cap stocks are as cheap today as they have been in decades, Wall Street is still not bullish on the sector. According to Ned Davis Research, hedge funds' net short positions in Russell 2000 futures are the largest on record.
The most dangerous stocks
According to the latest Bloomberg report, a debt wall of more than $600 billion looms over the most dangerous stocks in the market. Companies in the small-cap Russell 2000 hold a total of $832 billion in debt, 75% of which ($624 billion) will need to be refinanced by 2029, according to data compiled by Bloomberg. By comparison, only 50% of the S&P 500 companies will have their debt due by then.
Marija Veitmane, a Wall Street veteran and senior multi-asset strategist at State Street Global Markets, said: "Despite attractive valuations, we won't buy them yet, and we don't like small-cap stocks because they're more sensitive to economic slowdowns, more expensive to fund, and profits could be squeezed more." ”
Smaller companies, in particular, tend to have a considerable amount of floating-rate debt, usually in the form of loans, as they are usually not large enough to borrow on the bond market. This means that shortly after the Fed raises rates, their interest payouts tend to be set higher, and large companies with fixed-rate bond debt may wait longer for interest rates to have a significant impact on their borrowing costs.
In addition, the performance of small companies is often related to the overall state of the economy. As a result, as changing economic conditions and uncertainty become the main theme in the market right now, Wall Street professionals are skeptical about buying the riskiest stocks, even at seemingly cheap valuations.
Guy Miller, chief market strategist at Zurich Insurance Company, said: "There's a reason why bigger, higher-quality companies cost more. They tend not to have any problems with financing and are not too dependent on interest rate policy. ”
So far this year, the Russell 2000 has risen just 1.6%, as expectations of Fed rate cuts have fallen from six in January to two, while the S&P 500, which represents large-cap US stocks, has risen 9.5%. Since the start of 2023, the S&P 500 has risen more than 36%, more than double the rise of the Russell 2000.
What's the problem?
Investors from the end of April, with a general lack of confidence in the stock market rally, flocked to the so-called "Magnificent Seven" tech giants, which are considered safer in times of economic uncertainty, leading to the Bloomberg "Magnificent Seven" total return index rising about 9% over the past three weeks. In contrast, according to Ned Davis Research, hedge funds' net short positions in Russell 2000 futures are the largest on record.
Bloomberg notes that the issue for small-cap stocks now is interest rates and the direction of the economy, as inflation remains more persistent than expected at the start of the year.
Earnings don't help small-cap stocks either. According to BI, Russell 2000's revenue grew by just 0.3% in the first quarter, compared to 4% for the S&P 500. Even if interest rates remain at current levels, small-cap operating income outside the financial sector could fall by 32% over the next five years, given that nearly half of debt is short-term or floating, according to a Bank of America analysis.
According to data compiled by Bloomberg, small-cap stocks are increasingly losing money, with about 42% of companies in the Russell 2000 currently having negative profitability, compared to less than 20% in the mid-90s. Hugh Grives, fund manager at the Premier Miton US Opportunities fund, said: "Russell's companies are significantly worse quality than they were 20 years ago, and more companies have been able to go public, but they have never been profitable and may never be profitable. ”
Analysts point out that if interest rates remain high for longer, it will be more negative for small-cap stocks, as such companies have more debt and higher borrowing costs.
Moody's issued a warning
Recently, a number of Federal Reserve officials have taken turns to release signals, suggesting that the Fed is still not in a hurry to cut interest rates in the short term. This has raised concerns for Moody's chief economist Mark Zandi. Zandi said that if the Fed does not cut interest rates in the coming months, there could be undesirable consequences. Zandi warned that if the Fed keeps interest rates at current levels, it will increase the risk of a recession and could expose other holes in the financial system. He noted that credit conditions in the U.S. are being "eroded" due to slower loan growth due to rising borrowing costs, which could put pressure on banks' balance sheets.
Marija Veitmane, senior multi-asset strategist at State Street Global Markets, also said that if the Fed delays cutting interest rates, it will have a material adverse impact on the economy. While the economy seems to be stable at the moment, persistently high interest rates could lead to more economic problems in the future. She predicts that if no adjustments are made, the economy may not achieve a smooth "landing" and may instead "crash".
At its monetary policy meeting that ended on May 1, the Fed announced that it would keep the target range for the federal funds rate unchanged between 5.25% and 5.5%. This is the sixth consecutive time that the Fed has left interest rates unchanged since September last year.
Despite warnings of long-term economic downside risks, the Fed is unlikely to ease monetary policy in the near term, as Fed officials remain cautious about the pace of inflation. The Fed is widely expected to keep interest rates unchanged at its next policy meeting. According to CME Group's FedWatch tool, most investors expect only one or two rate cuts this year, well below the six rate cuts expected at the start of the year.
On May 8, local time, Susan Collins, president of the Federal Reserve Bank of Boston, said that the Federal Reserve may keep the federal funds rate high for longer than expected to curb demand and reduce inflationary pressures. On May 10, US Federal Reserve Board Governor Michelle Bowman said that it would not be appropriate for the Fed to cut interest rates this year due to persistent inflationary pressures.
Editor-in-charge: Tactical Heng
Proofreader: Liu Rongzhi