A $600 Billion Wall of Debt Looms Over Market’s Riskiest Stocks

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(Bloomberg) — U.S. small-cap stocks are as cheap as they have been in decades, but with a mountain of debt of more than half a trillion dollars looming over the next five years, it will take a big signal of risk appetite from the Federal Reserve to attract investors. .

Data compiled by Bloomberg shows that companies in the Russell 2000 small-cap index have a total of $832 billion in debt, 75% of which — or $620 billion — needs to be refinanced through 2029. By comparison, companies in the index The large S&P 500 has only 50% of its liabilities outstanding by then.

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“No, despite attractive valuations, we won't buy yet,” said Maria Veitman, chief multi-asset strategist at State Street Global Markets. “We don't like small caps because they are more sensitive to economic slowdowns, have a much higher cost of financing, and margins are likely to come under more pressure.”

In particular, small businesses tend to have a large amount of variable-rate debt, usually in the form of loans, because they are often not large enough to borrow in the bond market. This means that interest expenses often reset higher soon after the Fed raises interest rates, while a larger company with fixed-rate bond debt may wait longer before higher interest rates have a significant impact on its borrowing costs. .

In addition, the performance of small businesses is usually linked to how the overall economy is performing. So, with changing economic conditions and uncertainty being the theme in markets right now, Wall Street pros are skeptical about buying into riskier stocks — even at seemingly bargain valuations.

The Russell 2000's price-to-sales ratio compared to the S&P 500 is near its lowest levels since 2003, excluding the lows during the Covid pandemic in 2020. But market participants still say the index is priced perfectly and will need a strong rebound. Next year. Economic growth to stimulate the rise.

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“Larger, higher-quality names are more expensive for a reason. They tend not to have any issues around financing and are less dependent on interest rate policy,” said Jay Miller, chief market strategist at Zurich Insurance.

Lagging performance

The Russell 2000 is up just 1.6% this year, as expectations for interest rate cuts dwindle to two from six in January, while the S&P 500 is up 9.5%. But small companies have been lagging large caps for a while, with the S&P 500 doubling the performance of the Russell 2000 since the start of 2023.

In fact, the small-cap index has gone two and a half years without peaking — its longest stretch since the global financial crisis, according to data compiled by Bloomberg. On the other hand, the S&P 500 index set and reset records 22 times in 2024.

The issue now for small businesses is the direction of interest rates and the economy as inflation remains firmer than expected at the start of the year.

The stock market situation shows a general lack of conviction in the stock rally that began at the end of April. Investors have again flocked to the so-called Magnificent Seven tech giants, which are considered safer during periods of economic uncertainty, sending the Bloomberg Magnificent 7 Total Return Index up nearly 9% in the past three weeks. By contrast, hedge funds have one of their largest net short positions in Russell 2000 futures on record, according to data from Ned Davis Research.

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Dividends don't help small businesses either. BI numbers show Russell 2000 revenue for the first quarter is on track to rise just 0.3% versus a 4% gain for the S&P 500. Strategists Michael Kasper and Jenna Martin Adams said the rest of 2024 is likely to see an “up and down recovery,” which could leave the Russell 2000 A bit fickle.”

An analysis by Bank of America showed that even if interest rates remain at current levels, operating profits of small businesses outside the financial sector are likely to fall by 32% over the next five years, given that nearly half of their debt is short-term or floating rate.

Cash banks

Small companies are increasingly losers, with about 42% of the Russell 2000 currently recording negative profitability, compared with less than 20% in the mid-1990s, according to data compiled by Bloomberg.

“The quality of companies in Russell is much worse than it was 20 years ago,” said Hugh Greaves, fund manager at Premier Mitton US Opportunities Fund. “You had a lot of companies that were able to go public that never made profits, and probably never will.”

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But Graves is also among the market forecasters who caution against ruling out all penny stocks. The other is David Lefkowitz, head of US equities at UBS Global Wealth Management, who sees lower interest rates by the end of the year supporting the group, and the expected rebound in trading activity translating into stronger earnings.

“It's not that small businesses are a bad thing,” said Lefkowitz, who increased his weight in the group in December. “It's just that on a relative basis, larger companies do better.”

Jill Carey Hall, a strategist at Bank of America, tells clients that “it makes sense to be selective” because pockets in the energy, materials and industrials sectors are attractive given their sensitivity to an improving economy and relatively low refinancing risks. But investors are proving a difficult sell.

“The feeling we have is that they are waiting for more confidence that inflation will slow and that the Fed will be able to start tapering,” she said.

And for Premier Miton's Grieves, it's not all about the beanie though. It's about that there are no reasons to avoid the tech giants that have been winners all along.

“What he keeps coming back to is the Seven Wonders,” he said. “Once they stop outperforming, you'll see fund managers start to get more excited about small caps.”

-With assistance from Sujata Rao, Jean-Patrick Barnert, Elena Popina, and Jessica Minton.

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