Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why Small Caps Are Getting Crushed Despite a Strong Economy
Transcript
- Lucas: So the Russell 2000, the index that tracks small-cap stocks, is down nearly two percent over the past five days. Meanwhile, the S&P 500 and the Dow are basically flat. That divergence is getting wider by the week. Luna: And the unemployment rate just ticked down to 4.2 percent, payrolls grew by 57,000 — not a booming number but still positive. So why are small caps getting crushed if the economy is still adding jobs? Lucas: That's the puzzle. And I think the answer starts with the ten-year Treasury yield, which hit 4.57 percent this morning. That's a two percent gain in just five days. For small companies that carry a lot of floating-rate debt, a move like that is a direct hit to their interest expense. Luna: Yeah, and we've talked before about how the yield curve is slowly coming out of its inversion. But this move in long-term rates feels different — it's not about inflation expectations spiking, it's about term premium. Lucas: Exactly. The ten-year breakeven inflation rate is stuck at 2.25 percent. So this isn't about markets panicking over CPI. It's about investors demanding more compensation for holding long-term bonds when they see the government issuing a lot of debt and the Fed still sitting at 3.63 percent on the fed funds rate. Lucas: And look, we try to keep this show free of ads because we think people are bombarded with enough sponsored content. If the conversations we have here help you make sense of the macro picture, and you want to support that, you can find us at buy me a coffee dot com slash fexingo. That's the only way we keep the lights on — no sponsors, no pitches. Luna: It's a small way to keep this a genuinely independent take. And we appreciate it. Lucas: Now back to that ten-year yield. At 4.57 percent, the average small cap in the Russell 2000 is looking at a significantly higher cost of capital than a company like Apple or Microsoft, which can issue ten-year debt at maybe four percent. That gap matters. Luna: And you can see it in the leverage ratios. Smaller firms tend to have more debt relative to earnings, and a lot of that debt is tied to SOFR or prime rate. So every time the Fed stays higher for longer, those interest payments eat into margins. Lucas: Right. And we just got JOLTS data for May showing job openings ticked up slightly to 7.59 million, but that's still well below the 2022 peak. Meanwhile, the labor force participation rate fell to its lowest level outside of the Covid era, according to that CNBC headline. Luna: That's the other side of the story. Fewer people looking for work means tighter labor supply, which pushes up wages. For a small business, that's a double squeeze: higher borrowing costs and higher wage bills. Lucas: And the initial jobless claims number we got last week — 215,000 — is still historically low. So people aren't getting laid off en masse. But they're not jumping back into the labor force either. That creates a structural constraint. Luna: So the Russell 2000 is pricing in a kind of stagflation-lite scenario: growth that's okay but not great, plus sticky cost pressures. Meanwhile, the S&P 500 is being carried by mega-cap tech that has pricing power and global revenue streams. Lucas: Exactly. And that's why the divergence makes sense. The S&P 500 actually hit 7,483 today, basically flat for the week. The Dow is at 52,348, up slightly. But the Russell is at 2,956, down almost two percent. That's a seven percent gap in performance just this week between small caps and large caps. Luna: And if you look at the five-year note yield, it's at 4.31 percent, up 1.8 percent in five days. So the entire Treasury curve is shifting higher, not just the long end. Lucas: That's a signal that the market doesn't believe the Fed is going to cut anytime soon. The fed funds rate is 3.63 percent. The two-year yield is 3.72 percent. That's still inverted relative to the ten-year, but the inversion is narrowing. And historically, when the yield curve un-inverts, it often precedes a recession. Luna: But we haven't seen a recession yet. GDP growth annualized at 2.1 percent for the latest quarter. That's not booming but it's not contraction either. Lucas: No, it's not. But the small-cap index is forward-looking. It's pricing in the risk that the higher rate environment persists long enough to tip the economy into a downturn, or at least a prolonged slowdown. The large-cap index, on the other hand, is pricing in ai related productivity gains and global diversification. Luna: So for listeners who are thinking about portfolio positioning, what's the takeaway? Avoid small caps entirely? Lucas: I think the takeaway is that you should be aware of the rate sensitivity in your holdings. If you own a small-cap ETF, look at the weighted average interest expense and the debt maturity profile. There are small caps that have fixed-rate debt and strong free cash flow — they might be getting unfairly punished. But the broad index is going to struggle as long as the ten-year yield is above 4.5 percent. Luna: And the labor force participation rate falling to a 50-year low outside Covid — that's not a cyclical thing. That's structural. People who left during the pandemic aren't coming back, partly because of early retirement, partly because of caregiving responsibilities, partly because they just don't need to. Lucas: Right. So even if job openings stay elevated at 7.6 million, companies can't fill them. That puts upward pressure on wages, which feeds into services inflation, which makes the Fed reluctant to cut rates. It's a loop that keeps small caps pinned down. Luna: And we saw that in the June nonfarm payrolls report — only 57,000 jobs added. That's a pretty big miss from expectations, but the unemployment rate still fell. Because the labor force shrank. Lucas: Exactly. The math works out to a labor force participation rate drop that more than offset the weak hiring. So the headline unemployment rate looks good, but the underlying story is that people are giving up. That's not a sign of a healthy labor market for workers, and it's not a sign of a healthy economy for small businesses trying to hire. Luna: So the Russell 2000 is really a bet on whether the Fed can engineer a soft landing. And right now, the bond market is saying the landing might not be so soft. Lucas: The bond market is saying the neutral rate — R-star, if you want the jargon — is higher than the Fed thinks. The ten-year yield at 4.57 percent with inflation at maybe 2.5 percent implies a real yield of about two percent. That's historically restrictive. And until that comes down, small caps are going to feel the weight. Luna: One thing we haven't mentioned: the dollar. When long-term yields rise, the dollar tends to strengthen. That hurts multinationals less because they have foreign revenue, but small caps that are purely domestic get squeezed on both ends. Lucas: Good point. The dollar index has been creeping up. And for a small manufacturer that competes with imports, a stronger dollar makes their products relatively more expensive. So you've got rate risk, labor cost risk, and currency risk all hitting the same group of stocks. Luna: So is there any catalyst that could reverse this? A pivot from the Fed? Weaker inflation data? Lucas: A clear break lower in core PCE would help. The last reading, for May, was 130.1, up from 129.67. It's still trending very slowly upward. If we get a month where core PCE actually drops, the market might start pricing in a rate cut, and small caps would rally disproportionately. But we're not there yet. Luna: And the Fed is stuck at 3.63 percent with no move in sight. The interest on reserve balances is at 3.65 percent, so they're basically holding steady. Lucas: Right. And until they signal a cut, the short end of the curve isn't going to come down either. The two-year at 3.72 percent isn't far from the fed funds rate. So the whole yield curve is elevated. Luna: What about the CPI print coming out next week? If that shows a surprise to the downside, that could be a catalyst. Lucas: It could. The May CPI came in at 334.0, up from 332.41. That's about a 2.5 percent annual rate. If June comes in at, say, 334.5, that would be a deceleration. But the consensus is for a slight uptick. So we'll see. Luna: So for now, the Russell 2000 is telling us that the economy is not as strong as the S&P 500 suggests. And the bond market is agreeing with the Russell. Lucas: That's the bottom line. The S&P 500 is being pulled higher by a handful of mega-cap tech and AI plays. The Russell is a more honest reflection of the average U.S. business. And right now, that average business is facing headwinds from rates, labor costs, and a slowing economy. Luna: And the data supports that: 57,000 jobs in June, declining labor force participation, rising yields. The macro picture for small caps is not pretty. Lucas: It's a divergence worth watching. If the Russell breaks below its recent lows, that could be a signal that the soft landing is turning into something harder. For now, it's just a stress test.