From March 2022 to July 2023, the Federal Funds Rate crept higher and higher in efforts to wrangle runaway inflation. As a result, the U.S. economy has functioned in what we could call a structurally higher rate environment, compared to the recent past.
Now, jobs data and sticky CPI reports are suggesting we may need a lightening up of the interest rate path. Sure, we’ve had a few rate cuts so far, but you may wonder: What’s at stake if the next part of this saga entails a longer path of rate reduction? What are the implications for large versus small caps, and which sectors might see windfalls? Let’s walk through possible outcomes and how we consider them in active management.
Over the last five years, small caps have markedly underperformed large caps and the broader market. In 2021, with the economy reeling from economic stimulus and global supply chain backlogs resolving themselves, smalls were ripping. But by November 2024, small caps were trailing by around 19 percentage points. Today, that gap is closer to 40 percentage points. So, what gives?
Some, but not all, small companies may use a moderate to significant amount of debt to finance their growth. Higher debt costs can entail shrinking returns and cash for shareholders. Because these companies operate on a smaller scale compared to large and mega cap peers, their capacity to leverage operating costs to maintain earnings and cash flow tends to be relatively condensed.
Small caps also historically have experienced lower trading volumes, on average. Putting these three factors together feeds the flywheel for the negative sentiment and selling behavior that we’ve observed over the last three and a half years. We believe a reduction in borrowing cost—that may or may not come with increased economic activity—could lighten the pressure small caps are under.
There are a few views to be had on an approaching decline in the Fed Funds Rate. Some investors believe cuts indicate hard times ahead, others are focused on the relief for capital investment costs, and still others on the potential relief in housing, durables, and other consumer-centric expenditure.
In determining what might stick, I like to consider what rate changes mean for explicit (tangible) costs across different sectors. In industrials, particularly construction, the long lag of rate hikes had us in a 10-month down streak for construction put-in-place, which has been falling year-over-year since Spring 2024.1 Data Center growth has taken off like a shot, but outside of AI-related projects, capital spending is a meager two percent on the whole. Should construction find some relief in lower rates, and therefore a reduction in some of their explicit costs, a return of breadth to that sector could present an opportunity for growth.
Industrials aren’t the only potential benefactor, though. Consumers face the direct effects of higher interest rates when they pay the mortgage man and when they finance durable goods like automobiles or certain home appliances and/or projects. Households are also up against the increased costs of goods and services that businesses might pass onto them because of higher borrowing costs.
Lower rates don’t guarantee a basket-filling windfall for consumer-facing companies, but a reduction in explicit financing costs—from one’s own home to what a CPG company pays for supply chain financing and eventually passes on—begs us to consider where gains might be captured.
This wouldn’t be a financial newsletter without a sports metaphor, right? Baseball players can’t predict exactly where in the field a hit will end up. Instead, they position themselves across the infield and outfield to increase their chances of fielding the ball to deny base runners.
Active management in this market looks much the same and, at Motley Fool Asset Management, we’re playing a game with four main "positions" rather than nine. By adhering to high standards to our Four Pillars of Quality (Management, Culture, & Incentives, Economics, Competitive Advantage, and Trajectory) we aim to increase our chances of making the catch, whether the market hits us with a line-drive of low rates or a deep-center fly of runaway inflation.
So, rather than trying to time the market with a faulty crystal ball, we play the field 24/7 with our big four. Leaning into quality doesn’t mean we always "win", but we believe it certainly makes for well-guarded bases and opens the window for alpha.