The record shows that in both U.S. and non-U.S. markets, microcaps and small caps have had higher returns than large caps during periods of rising interest rates.
What was perhaps the most anticipated Federal Reserve rate increase in the history of mankind now feels like the distant past. After a brief market rally at the end of the year, we witnessed the worst start to a calendar year in history. As fears mounted in the first quarter, many investors predicted recession and a risk-off mentality from investors punished smaller stocks.
Now we are left to consider next steps. Notably, smaller stocks have lagged larger names for one, three, five and 10 years on an annualized basis. So what next? For investors in microcap and small-cap funds, the answer is potential longer-term outperformance relative to large-cap funds. Simply put, we view this dislocation and environment as an opportunity.
A look at the record finds that in both the U.S. and non-U.S. markets, microcaps and small caps have had higher returns than large caps during periods of rising interest rates. Furthermore, the relative returns generated during these periods were greater than the long-term relative return premium normally associated with investing in these asset classes.
DEBT LEVELS
One important factor influencing these returns is debt. During periods of economic expansion, large-cap companies tend to use leverage more aggressively to make acquisitions and fund stock buybacks, among other purposes. That has especially been the case during this prolonged period of historically low interest rates, which has seen the levels of debt carried by large-cap companies expand dramatically. Rising rates make borrowing more expensive. On the other hand, microcap and small-cap companies tend to carry much lower levels of debt on their balance sheets, making them less vulnerable to a rate increase.
There may be another reason these asset classes tend to outperform: Periods of rising rates are generally associated with a more rapidly growing economy, and this often benefits smaller companies disproportionately.
Using Fama-French data from 1963 through 2014, we identified 10 distinct periods where the yield on the 10-Year U.S. Treasury was rising. In six of the 10 periods, microcaps outperformed small caps. In seven of the 10 periods, small caps outperformed large caps.
Additionally, we found that returns during these periods are even more favorable than the long-term return premium associated with investing in microcaps and small caps relative to large caps. For example, the average annual return premium in periods of rising rates for microcaps over small caps was 4.13%, while the annualized relative return over the entire period was just 2.24%. The average annual return premium for small caps over large caps during the 10 periods of rising rates was 7.60%, while the annualized relative return of small caps over large caps from 1963 to 2014 was 2.55%.
Although returns generally favored smaller stocks over the period under review, they were less favorable for small caps and microcaps after September 1981, due to the persistent long-term trend of declining interest rates. While there were short periods of rising rates after Sept. 30, 1981, the long-term trend in rates was lower. From Sept. 30, 1981, through 2014, yields dropped from roughly 15% to 2%, and microcaps underperformed small caps, although only by 0.27% on an annualized basis. Conversely, the relative performance of small caps and microcaps was distinctly positive during the period from 1963 to Sept. 30, 1981, when yields rose from roughly 4% to 15%. During that time period, microcaps outperformed small caps by 2.91%, and U.S. small caps outperformed U.S. large caps by 5.02%, on an annualized basis.
A NEW ERA?
In the statement accompanying the announcement that it would immediately lift the funds rate by a quarter point, the Fed indicated that this was just the first of a likely series of rate increases over the next 12 months. Assuming the economy cooperates, investors may face a prolonged period of rising rates for the first time in decades, perhaps similar to that experienced in the period from 1963 to Sept. 30, 1981. For many, this will be a first.
Rising rates will inevitably result in a divergence in the performance of various asset classes. As advisers look to reposition investor portfolios to take advantage of this, they will look to the historical record for guidance. We know that not all equities will do equally well going forward, and when recession fears abate, risk assets perform well. Given valuations and the historic outperformance of microcaps and small caps in periods of rising rates, this end of the market is worth a close look.
Chris Tessin is a founder and managing partner of Acuitas Investments, a boutique asset management firm providing access to capacity constrained areas of the equity markets.
