Latest / Inflation and Your Money with Fexingo: Protecting Purchasing Power and Beating Inflation / Why Small Caps Are Beating Inflation Hedges
Transcript
- Lucas: So I was looking at the market numbers this morning, and one thing jumped out at me: over the past five days, the S&P 500 is basically flat — up just 0.1 percent. But the Russell 2000, the small-cap index, is up 3.1 percent. Luna: That's a big gap. What's driving it? Lucas: Well, the usual story is that small caps get hammered when inflation is sticky because they're more sensitive to interest rates. But this time, it seems like investors are betting that smaller companies can actually pass on higher costs more easily than the big guys. Luna: Right, because they're more nimble, they can adjust prices faster. And a lot of them are domestic-focused, so they're less exposed to the global supply chain mess. Lucas: Exactly. Meanwhile, the traditional inflation hedges are not doing so well. Gold is down 3.1 percent over the same period, and even TIPS — Treasury Inflation-Protected Securities — have been losing ground as real yields rise. Luna: It's interesting because the 10-year breakeven inflation rate is still at 2.29 percent, which is down a bit from 2.34 last week, but still above the Fed's target. So inflation expectations are still elevated, yet gold is falling. Lucas: That's the disconnect. Gold usually rallies when inflation fears spike, but right now it's being weighed down by a stronger dollar and the fact that the Fed isn't cutting rates anytime soon. The effective fed funds rate is at 3.63 percent, and the interest on reserve balances is 3.65 percent. That makes holding gold — which yields nothing — less attractive. Luna: So if gold isn't working as an inflation hedge, and TIPS are also struggling, what should people look at? Are small caps really the answer? Lucas: I think they're part of it. The Russell 2000 is up 3.1 percent in five days, that's a real move. But you have to be selective. Not all small caps are created equal. The ones with pricing power — think niche manufacturers, local service providers, companies that sell essentials — those are the ones that can pass on costs. The ones that are highly leveraged or in discretionary spending might still struggle. Luna: Right. And we should mention that the Russell 2000 is still down for the year overall, if I remember correctly. So this could just be a short-term rotation. Lucas: Yes, year-to-date the small caps are actually negative, I think around minus 4 percent or so. But the point is, in this environment where inflation is sticky but not accelerating — CPI is at 334.0, up from 332.41 last month — the market is trying to figure out what works. And small caps might be a better real-world hedge than gold. Luna: Let's dig into why that is. I mean, gold has been the go-to for thousands of years. Why would small caps be better now? Lucas: Because inflation isn't just about money supply anymore, it's about specific bottlenecks. Small companies that operate locally can adjust their prices almost in real time. A plumber in Austin can raise his rates next week if his costs go up. A multinational like Procter & Gamble has to think about global pricing strategies, retailer relationships, and brand perception. So the small guy has more flexibility. Luna: That makes sense. Also, small caps tend to have more exposure to the domestic economy, which is still growing, albeit slowly. The GDP numbers haven't been great, but they're not negative. Lucas: Right. And the other factor is that small caps are often undervalued relative to large caps. The price to earnings ratio on the Russell 2000 is about 15, while the S&P 500 is around 22. So there's a value argument too. If inflation stays sticky, investors might rotate out of expensive growth stocks into cheaper value plays, and small caps fit that bill. Luna: So what's the catch? Why isn't everyone piling into small caps? Lucas: Volatility. Small caps can get crushed in a recession. If the Fed keeps rates high and the economy slows, small companies with variable-rate debt could get squeezed. Also, liquidity is lower, so when everyone tries to sell at once, the drop is steeper. That's the risk. Luna: So it's a trade-off. You get better inflation pass-through but higher risk. How do listeners think about this in their own portfolios? Lucas: I'd say don't go all-in. Maybe a 10 to 15 percent allocation to a small-cap value ETF, something like IWM or AVUV. And pair it with other inflation hedges that are actually working, like real estate or commodities — but not gold, at least not right now. Luna: You know, speaking of what's working — before we go further, I just want to say, if you find these conversations useful, we really appreciate the listeners who support the show. A couple of dollars a month is genuinely what keeps these going — buy me a coffee dot com slash fexingo, if you've gotten something out of them. Lucas: Yeah, absolutely. It's a small way to keep the show ad-free and independent. We're not trying to sell you anything. So if you value that, it helps a lot. Luna: Alright, back to small caps. So we've established that they have advantages in this environment. But what about the recent IPO market? SpaceX is about to go public at a massive valuation. Does that change anything for inflation hedges? Lucas: Not directly, but it shows that there's a lot of capital chasing growth, even in a high-rate environment. The SpaceX IPO is raising $75 billion at a valuation over $1.8 trillion. That's massive. But it's a large-cap story. For small caps, the IPO market has been pretty quiet. So the real action for smaller companies is still in the secondary market. Luna: Right. But if the SpaceX IPO does well, it could boost sentiment overall, and that might spill over into small caps as well. Lucas: Could be. But I think the main driver for small caps right now is the inflation dynamic. If inflation stays around 3 percent, and the Fed holds rates where they are, small caps could continue to outperform. If inflation drops quickly, then large-cap growth stocks might come back. Luna: So what's your bet? Are we in for a period of sticky inflation? Lucas: Looking at the data, core CPI is at 336.1, up from 335.42. That's not accelerating, but it's not decelerating either. The PCE price index, which the Fed prefers, is at 130.9, up from 130.38. So inflation is still above target. I think we're in this zone for a while. That favors the small caps. Luna: Alright, so for listeners who want to act on this, what's the one concrete step? Lucas: Take a look at your portfolio's exposure to small caps. If you're heavy on large-cap growth, maybe trim 5 percent and put it into a small-cap value ETF. Not a huge bet, but a tilt. And don't forget to rebalance regularly — that's key in this market. Luna: Sounds like a plan. Thanks, Lucas. Lucas: Thanks, Luna. That's it for today — we'll be back tomorrow with another angle on protecting your purchasing power.