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One of Wall Street's favorite calls to start 2024 has flopped

A popular 2024 trade on Wall Street is on pause amid uncertainty over when the Federal Reserve will cut interest rates.

Many stock strategists began the year harping on a rebound in small-cap performance as consensus believed the Fed would begin reducing rates in the first half of 2024. Now, with the market scaling back its hopes for interest rate cuts this year, the small-cap Russell 2000 Index (^RUT) is down nearly 3% year to date, underperforming the S&P 500's more than 5% gain this year.

"We think the Russell 2000 could be a bit challenged in the near term until we get to kind of greater confirmation of inflation slowing and greater confirmation that, OK, the Fed is going to be able to start cutting rates," Bank of America head of US small- and mid-cap strategy Jill Carey Hall told Yahoo Finance.

After recent conversations with investors, Hall said the main catalyst for small caps to move higher is more clarity on the Federal Reserve's interest rate path. This reasoning remains largely unchanged from why investors liked small caps to start the year.

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But investors have been given little assurance that rate cuts are coming anytime soon. Market consensus has shifted from projecting seven rate cuts this year in early January to two rate cuts this year, per Bloomberg data. The move has put a significant damper on the rally seen in small caps to close 2023, while large-cap stocks have still clung to gains this year.

Recent research from Morgan Stanley chief investment officer Mike Wilson shows that interest rate sensitivity has been far greater in small caps versus large caps amid a recent rise in Treasury yields.

"Small caps and lower quality areas of the market [have] underperformed given their greater sensitivity to a rise in rates and more levered balance sheets," Wilson wrote on April 15. "We maintain our large cap quality bias across both cyclicals and growth."

A chart from Morgan Stanley chief investment officer Mike Wilson shows small cap stocks have reacted more negatively to the rise in the 10-year Treasury yield than large cap stocks.
A chart from Morgan Stanley chief investment officer Mike Wilson shows small cap stocks have reacted more negatively to the rise in the 10-year Treasury yield than large cap stocks.

The key difference is the companies' debt structure. Small caps have more than 40% of their debt in the form of floating-rate loans, which are exposed to current interest rates, or short-term debt that may need to be refinanced amid the higher rate environment. This compares to the roughly 75% of long-term fixed debt for S&P 500 companies, per Bank of America's research team.

Add in that large cap companies often have more cash that could benefit from higher rates and that the Fed holding rates steady is simply more costly for smaller companies than larger companies.

"The [Russell 2000] index is very sensitive to credit and rates," Hall said. "Refinancing risk is a key risk for these companies given that large caps were able to lock in a lot of long-dated fixed rate debt. ... The longer rates stay high, that becomes a bigger and bigger risk to earnings for these [smaller-cap] companies."

FILE PHOTO: The Wall Street entrance to the New York Stock Exchange (NYSE) is seen in New York City, U.S., November 15, 2022. REUTERS/Brendan McDermid/File Photo
The Wall Street entrance to the New York Stock Exchange (NYSE) is seen in New York City, on Nov. 15, 2022. REUTERS/Brendan McDermid/File Photo (Reuters / Reuters)

Signs that the economy is continuing to grow at a better-than-expected pace this year keep part of the bull case for small caps intact, Hall said, as profits are projected to rebound later this year.

Goldman Sachs Asset Management portfolio manager Greg Tuorto, who still sees opportunities in small caps, agreed with Hall.

"The underlying strength in the economy is something that always does drive small caps," Tuorto told Yahoo Finance. "It's a very domestic asset class. Very much driven directly by what's going on in the US economy. So the strength in the US economy should not be discounted in small caps."

But shifting expectations for Fed cuts remain a headwind for the group, Tuorto said, and that's been the bigger driver of market action recently.

Josh Schafer is a reporter for Yahoo Finance. Follow him on X @_joshschafer.

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