By Francis Gannon, Co-CIO at Royce & Associates
We’ve been arguing for a while now that the economy and markets are on the road back to normal. In fact, we recently observed that the economy has reached that condition, and we are now waiting for the market to catch up.
Accelerated GDP growth and the early signs of inflation—mostly being felt in increased commodity, raw material, and other input costs—are more historically familiar economic territory.
History also shows that these developments are typically coincident with rising interest rates. So far, though, the 10-year Treasury yield has stubbornly refused to acquiesce to history—making the 10-year the major road block on the path back to normal.
But with other developments firmly in place, including short rates that are on the rise, we believe that the upward trend in rates is under way—and we suspect that the 10-year yield will begin to move up more consistently over the next year.
As small-cap specialists, we see all this as healthy. Once again turning to history as our guide, we find that periods of rising rate have been favorable for small-cap stocks on both an absolute and relative basis.
When the 10-Year Treasury yield was rising, the Russell 2000 Index outperformed the large-cap Russell 1000 in 70% of trailing monthly rolling one-year periods for the 20-year period ended 6/30/18, with an average one-year return of 23.8% versus 19.2% for large-cap.
How Have Small-Caps Performed When Rates Are Rising?
Russell 2000 vs Russell 1000 Trailing Monthly Rolling 1-Year Returns When 10-Year Treasury Yield was Rising From 6/30/98 through 6/30/18
10-Year Treasury Yield rose in 92 of 229 periods.
More specifically, we see rising rates as a phenomenon that should also be helpful to risk-conscious active managers in the small-cap space—primarily because it fosters an environment where better balance sheet companies are likely to be rewarded for their fiscal prudence. In other words, risk management matters.
This is especially relevant today because of the increased leverage—specifically financial leverage—within the Russell 2000. And as rates continue to move up, the small-cap index looks increasingly risky.
As active managers, we have the ability to screen and scrutinize small-cap businesses with better balance sheets and shy away from those with what we see as having excess financial leverage. And it’s worth mentioning that the market has largely ignored better balance sheet companies for much of the last 10 years.
Most of our strategies gravitate toward companies with low debt. We’d rather focus on companies that have great operating leverage—but not financial leverage.
The market seems to be transitioning into an environment that will favor similar qualities.
Important Disclosure Information
Mr. Gannon's thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and / or Russell ratings or underlying data and no party may rely on any Russell Indexes and / or Russell ratings and / or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index. The Russell 1000 index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.
Francis Gannon is the Co-Chief Investment Officer at Royce & Associates, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
©2018 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC is a subsidiary of Legg Mason, Inc.
All investments involve risk, including loss of principal. Past performance is no guarantee of future results. Equity securities are subject to price fluctuation and possible loss of principal. Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional. Small-cap stocks involve greater risks and volatility than large-cap stocks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.