The Bottom Line
- Small-cap stocks might not be the first thing that leaps to mind when considering how to diversify a traditional stock/bond portfolio against rising interest rates.
- Yet smaller company equities in general have had less correlation to investment-grade bonds than large-cap stocks—which suggests lower sensitivity to interest rates, a primary driver of bond prices.
- How to explain that relationship? Small-cap specialist Royce & Associates believes the main reason is that smaller companies in general are more directly tied to domestic growth than larger ones, which can receive substantial revenues from operations outside the U.S.
- Since economic growth and rising interest rates often go hand in hand, small-caps may be well positioned to thrive in the months to come.
- Consider the previous decade’s Fed interest rate tightening cycle, which saw the federal funds target rate rise from 1% to 5.25% between June 2004 and June 2006.1
- During that time period, the Russell 2000 generated a two-year cumulative total return of 25.3%—versus 15.5% for the S&P 500, 5.76% for the Bloomberg Barclays U.S. Corporate Bond Index and 5.26% for Bloomberg Barclays U.S. Treasury Index.
- The Russell 2000 Value Index—which tends to be more cyclically oriented than the broader Russell 2000—did even better, generating a two-year cumulative total return of 30.87%.
- Of course, the past isn’t always a guide to the future. But with the Fed hoping to move toward interest rate normalization, investors shouldn’t overlook the potential benefit of a small-cap allocation.
- For additional insight on small-cap investing please see More Volatility Could Be Good For Small Caps and Natural Fit: Rate Hikes and Small-Cap Value.
1 Source for all data is Bloomberg.