How Will Rising Rates Affect Small-Cap?
article , video 08-09-2018

How Will Rising Rates Affect Small-Cap?

Co-CIO Francis Gannon discusses why he thinks bond yields will rise and how that might affect small-caps.


Why do you think bond yields will rise?

One of the aspects of the market we’ve been talking about now for several years has been we’re going to be entering a more normal environment, and in a more normal environment you’re going to see rates higher than they are today. Just given the fact that we’re seeing accelerating economic growth and higher inflation, all of which we think as an active manager is actually quite positive.

Rising Inflation
Core Personal Consumption Expenditure Price Index Seasonally Adjusted YR/YR


The “core” PCE price index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

It means that companies that have better balance sheets are going to be rewarded, as opposed to penalized as we saw during the zero-interest rate policy world. So rising rates we view as healthy. We’re going to go through fits and spurts like we saw in the second quarter of this year, when we saw the 10-year rise above 3% and then retreat. And then there’s moments of time we’ll be frustrated as value investors as growth comes back into play and some of the bond-like proxies in the small-cap space do quite well.

How do you think rising rates will affect small-cap stocks?

Rising rates are going to be helpful to active managers and risk managers within the small-cap space. One of the things we’re seeing, we think from a financial leverage perspective, is that the Russell’s becoming increasingly risky. And active managers have a chance to shine here in a rising rate environment, because one of the things we tend to focus on are under-levered businesses. We’d rather focus on companies that have great operating leverage but not financial leverage. In today’s world, where rates are going to be tending to be moving higher, we think you’re seeing increased leverage in the Russell 2000, which makes it increasingly risky and something investors should be aware of.

Why did the market seem out of sync with economic growth this quarter?

In the second quarter we’re getting more and more evidence that the domestic economy at least seems to be picking up steam a little bit in terms of overall GDP and GDP growth, which we think is quite healthy. The interesting aspect of it was that we didn’t see that play through with many of our more economically sensitive or cyclical businesses. And I think that’s part of the market being the market. Kind of a coy answer, but in reality, that’s what it is. You know, our job as fundamental analysists and bottoms up researchers are actually to follow the fundamentals, invest in businesses on fundamentals.

As risk managers, we see a lot of opportunity in these economically cyclical businesses that have not been recognized yet by the market, and we see a lot of risk in the non-earner part of the market. Those parts of the market that actually did quite well in the second quarter, led by healthcare. And so as we look forward, you know, for the next three to five years, which is our job, to look out three to five years, and invest for a longer period of time, we’re finding solid fundamentals in these more economically sensitive and cyclical areas of the, of the world today that the market, at the moment, has not recognized. In the end we think it will all flush out and better businesses should be rewarded.

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The thoughts and opinions expressed in the video are solely those of the persons speaking as of July 9, 2018 and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

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