Higher yields are raising concerns that it will cost more for small companies to borrow
NYSE
After a fierce run, smaller-capitalization stocks were hit by profit-taking this week, amidst a spike in Treasury yields. But gains still lie ahead for small caps, which are supported by strong earnings growth and reasonable valuations, analysts say.
The Russell 2000, an index of small caps, fell more than 1% during the week ended Friday. By comparison, the large-cap S&P 500 fell only about a half a percentage point over the same time span. Meanwhile, the 10-year Treasury yield jumped to 1.36% from 1.2%.
The higher rate of return on the risk-free bond makes owning stocks less attractive. Another problem: While typically, higher yields are positive harbingers of growth for smaller companies, which are more economically sensitive than larger ones, that’s when yields are rising gradually. “The concern comes if there are large and rapid spikes [in yields],” as happened during the week, Yung Yu Ma, chief investment strategist at BMO Wealth Management told Barron’s.
In fact, the spike in yields led to concerns that funding will cost more. Small companies tend to rely more on borrowing than on issuing new equity to raise money.
“Small companies are more dependent on debt to fund operations,” Tom Essaye, founder of Sevens Report Research wrote in an note. Rising rates also reduce the value of future profits, leading to lower expectations for current stock prices.
Investment-grade interest rates have risen only slightly in 2021 — a year that has seen Treasury yields pop — but investors fear substantially higher borrowing costs in the near future, Quincy Krosby, chief market strategist at Prudential Financial, told Barron’s.
This all comes after small caps have had a strong run. Since the small-cap rally began on Sept. 23, the Russell 2000 has returned 55%, versus 21% for the S&P 500.
The increase in yields was especially bad for small cap growth stocks, with the Russell 2000 growth index falling about 2% during the week, while its value counterpart barely budged. That’s no surprise: Growth-stock valuations are more sensitive to changes in interest rates. Higher rates erode the value of future profits and growth firms expect the bulk of their profits farther in the future. Moreover, small growth stocks traded at frothy valuations less than two weeks ago, while small cap value stocks are trading at tamer valuations versus large caps.
Still, the decline in small stocks seems to be a short-term adjustment, not a more sustainable trend, analysts say. Indeed, stronger earnings well into 2022 resulting from inoculations against the coronavirus, reopenings and trillions of dollars of fiscal stimulus could easily carry these stocks higher.
“This isn’t the death knell for small- and mid-cap stocks,” Krosby said.
Write to Jacob Sonenshine at [email protected]
