By Claudia Pagazani, director of portfolio and risk analytics at Baron Capital
The US stockmarket’s resilience in 2023 – underpinned by easing inflation, a strong labour market, and the Federal Reserve (Fed) signalling a pause and potential lowering of rate rates – came as a welcome development for investors.
This follows a period of significant turbulence in both equity and fixed income markets, beginning in March 2022 when the Fed initiated the steepest and fastest monetary tightening cycle seen over the past four decades.
The Fed has maintained a cautious stance, reflected most recently in its August 2024 meeting with the continuing prioritisation of bringing inflation down to its 2% target. Mixed economic signals mean that there is little certainty about when the Fed will take the decision to begin cutting rates.
Regardless, investor optimism about the easing of monetary policy has been reflected in an increase in stock prices beginning in the fourth quarter of 2023.
Decreasing interest rates often signal a more accommodative monetary policy which may boost investor confidence and lead to higher stock prices. Analysis of historical data shows that this can be particularly supportive for US small-cap stocks, which have historically tended to outperform during those periods.
See also: How to invest in an interest rate falling world
There have been three periods of sustained Fed Funds rate cuts since the beginning of the 2000s. The burst of the dotcom bubble in late 2000 marked the first of these as financial markets and economic conditions showed signs of weakness. In the period between November 2000 and early 2002, the Fed Funds rate fell from 6.5% to below 2%, with the US economy experiencing a recession.
During this period, most notably from March 2001 when the Fed Funds rate was at around 5.3%, and over the course of the following one-year period US small and mid-cap stocks outperformed large-caps by roughly 17% and 10% respectively. Both small and mid caps outperformed large caps on a forward basis (a relevant approach for assessing these periods, given that changes in interest rates take time before impacting businesses) at all times during this rate cuts period, including throughout the recession.
A similar trend can be seen during the next Fed Funds rate cut period in 2007-2008, a critical part of the US central bank’s response to the unfolding financial crisis. In less than 18 months, the Fed brought the rate from 5.25% to 0%. During this period, US small-cap stocks outperformed large caps on a one-year forward basis almost 100% of the time during the rate cut period and the recession. Mid-cap stocks also saw improvements on their forward relative performance, albeit a year after the first phase of the rate cuts.
The most recent period when the Fed reduced interest rates began months before the pandemic when, in 2019, the US economy was facing several challenges. These included concerns over an economic slowdown and trade tensions between the US and China, prompting the Fed to initiate a series of rate cuts as a pre-emptive measure to sustain economic expansion.
The outbreak of the pandemic in 2020 led the Fed to cut rates even more aggressively and implement additional monetary measures to support the economy in light of the massive disruptions being experienced.
See also: US jobs data gives Fed ‘reasons to cut, not to panic’
On this occasion, US mid caps generated better forward excess returns versus large caps in the initial stages of the rate cuts. While small caps did not outperform in the year after the initial rate cuts, this quickly changed with outperformance over large caps reaching above 50% during the one-year period after March 2020.
Analysis of longer-term historical data shows a largely similar picture with US small and mid caps tending to outperform large-cap stocks during periods of declining Fed Funds rates. In the nine rate cut periods since the 1970s, both small and mid caps underperformed large caps, on average, only during the 1984-1986 period. Small-cap stocks, on average, outperformed in the remaining eight periods, and mid caps in six of the nine periods.
It is important to keep in mind that each on these historical periods have been characterised by a unique set of economic and financial conditions, and the forward returns of US small and mid caps were likely influenced by multiple other factors in addition to interest rates.
Nevertheless, the data largely suggests that periods of Fed Funds rate cuts tend to be favourable for the subsequent relative performance of US small- and mid-cap equities.
Recent investor optimism about the prospect of lower interest rates has been tempered, in part, by the understanding that such cuts might signal underlying economic weakness. Despite the US economy’s resilience during the recent period of monetary tightening, there are concerns that the cumulative impact of higher rates could manifest more significantly during the remainder of 2024, resulting in a recession. If this happens to be the case while the Fed is reducing rates, US small and mid-cap investors should be well positioned.
