- Market volatility and weak inflation numbers have made September Fed policy rate cut a certainty
- Fed policy rates poised to head south from here; based on Fed Funds Futures, 8-9 rate cuts are expected by end-2025
- Larger proportion of debt for US small caps maturing in the short term, enabling them to refinance at lower rates (and enhancing profitability)
- Fund flows data suggests strong rebound in investors’ sentiments towards small-caps as the interest rate environment evolves
- At 17.7x, small-caps’ forward P/E is well below its 20-year average and this represents a 22.9% discount to the S&P 500
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September Fed rate cut a certainty amid soft inflation outlook. Since the release of June’s CPI data, the odds of a September Fed rate cut have surged to near certainty and the subsequent July numbers reaffirmed this view. Going by the Fed Funds Futures, traders are pricing-in a 100% probability of one rate cut in September and a 40% chance of a second cut during the meeting. Whether the Fed will go all out to cut 50 bps remains to be seen as the central bank would want to avoid being perceived as “panicking”. In any case, policy rates are poised to head south from here with 8-9 cuts expected by end-2025.
Fed policy easing positive for US small caps as rally broadens. Despite weaker-than expected jobs data, an economic soft landing for the US remains our base-case assumption and this is constructive for risk assets. As the US equity rally broadens, we expect small caps to benefit from a falling rates environment. Medium-term momentum for the small-caps space include:
- Rate cuts and lower borrowing cost to buoy small-caps earnings: Small-cap
companies tend to be more rates-sensitive given their debt structure. Indeed, small cap companies have a larger proportion of debt maturing within the next five years as compared to larger companies (c.67% for S&P 600 Small Cap vs. c.45% for S&P 500). As the Fed embarks on monetary easing, small-cap companies will be able to refinance at lower rates and reduce their borrowing cost. The latter is expected to contribute substantially to their bottom-line, with earnings growth for S&P 600 Small
Cap expected at c.20.3% in FY2025 (vs. c.14.0% for S&P 500). - Fund flows suggest renewed interest in US small-caps as rate cuts loom: In the three months leading up to June's CPI data release, small-cap equity funds registered consecutive weekly outflows. But since the release of June’s data (which fuelled
expectations of a September cut), small-cap equity funds saw a notable turnaround, attracting combined inflows of USD11bn in four weeks (ending 7 August). We expect this momentum to persist as investors reposition their portfolios in response to the
changing interest rates environment. - Attractive “broadening rally” play amid steep valuation discount: At 17.7x, the S&P 600 Small Cap index’s forward P/E is currently well below its 20-year average. Above all, the index is also trading at a 22.9% discount to the S&P 500 and this represents a compelling opportunity for investors looking to participate in the broadening rally.
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