uploads///Rising Interest Rates Have Been a Headwind to Small Cap Relative Returns

Where Are the Pockets of Value within US Stocks?

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2. Large-cap, cyclical stocks in the US.

In the US, I believe large-cap, cyclical-oriented companies look to be in a good position to withstand the start of the Fed’s tightening cycle. The US economic outlook is less than ideal, but US economic data in recent weeks still suggest a decent second-half to the year.

pockets of value within US stocks

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Market Realist – Pockets of value within US stocks.

The graph above compares the indexed performance of small caps (IWM) relative to mega- and large-cap stocks (OEF) in different interest rate scenarios over the last 20 years. We used the yield on the ten-year US Treasury (IEF) as a proxy for interest rates.

Small caps have outperformed large caps in the last 15 years or so, as interest rates have remained mostly low. However, during the last regime of rising interest rates between 2004 and 2006, the small caps underperformed.

Large caps tend to outperform small caps in a rising interest rate environment, while small caps outperform large caps when interest rates are low or falling. The rationale for this is that when interest rates rise, the extra cost of debt squeezes the margins of the small caps, while large caps have enough in their coffers to navigate the high-interest-rate period. As the Fed gets ready to hike rates, small cap returns could be subdued.

Cyclical sectors like technology (IYW) and financials (IYF) are likely to outperform as interest rates rise. The mature technology companies, like Apple and Microsoft, have very high amounts of cash and very low debt levels, unlike rate-sensitive sectors like utilities (IDU), which are likely to underperform as interest rates rise.

Meanwhile, the financial sector has been negatively impacted due to low interest rates, which have squeezed the interest spreads of the banks. With interest rates poised to rise, regional banks (KRE) are likely to perform better.

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