The S&P 500 rose to a record high this week, aided by strong performance by large tech-heavy multinationals. The benchmark US index has been aided by stellar performance among the ‘Magnificent Seven’,[1] as well as by a general increase in the price level. Once adjusting for inflation the S&P 500 is well above its end-2019 level, albeit still off its previous highs. However, the Russell 2000, which is made up of 2000 small-cap stocks, has floundered. Once the increase in the price level is accounted for, that index remains stuck at 2019 levels.
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Smaller US firms have suffered more than larger companies due to their higher exposure to interest rates which have experienced a sharp increase over the past two years. What happens next will depend on both the economic outlook and the associated path for rates. The average interest expense as a share of EBDITA was around three times higher for the Russell 2000 than the S&P 500, and so Federal Reserve action may prove to be particularly important for these smaller firms. Federal Reserve policymakers continue to guide the market towards easing. However, economic developments and some public comments have resulted in investors pushing out the timing of the first cut, and reducing the absolute amount delivered by the end of the year. Indeed, 50 basis points in easing has been priced out in recent weeks. Moreover, investors continue to anticipate that the fed funds rate will settle around 100 basis points above the median FOMC estimate for its neutral rate. Both would be headwinds to smaller companies.
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As the US economy continues to convalesce from the COVID and inflationary shocks, the path for interest rates remains uncertain. If current disinflationary trends persist, a pattern of easing may well be warranted. However, the latest data point to an acceleration in economic activity in recent months. Jobs growth seems to have picked up momentum, while there has been an uptick in survey measures of activity. Given that the economy appears to have been able to absorb the Fed’s hiking cycle better than many anticipated, that may encourage Fed policymakers to stay put and wait for clearer signs of disinflation or labour market weakness.
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One risk is that by waiting for the data to turn, policymakers leave it too late. That would be bad news for investors in both small and large US companies. Recent wobbles with New York Community Bank highlight ongoing pockets of risk in the financial system. Meanwhile, we have previously flagged the potential for a bout of corporate failures from a prolonged period of higher interest rates. We will cover these topics in further detail in Fathom’s forthcoming Global Outlook, Spring 2024. Charts and analysis will be available to LSEG customers via Chartbook.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
[1] The ‘Magnificent Seven’ equities are Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia and Tesla.
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