More Rate Cuts Seen as “Positive” for Small Cap Firms

Investing.com — Further potential interest rate cuts by the Federal Reserve this year could provide a boost to small-cap companies, although ongoing uncertainty regarding the U.S. economy may pose short-term challenges for these firms, according to analysts at Bank of America.

The Federal Reserve recently reduced interest rates by 50 basis points, bringing the range to 4.75% to 5.0%. This move signals the start of a cycle of easing aimed at supporting the economy following a lengthy fight against high inflation. Previously, interest rates had remained at a two-decade high for over a year.

In addition to the rate cut, an updated forecast from Fed officials indicated expectations for the benchmark federal funds rate to decline to between 4.25% and 4.5% by the end of 2024. This forecast implies either another significant half-point cut or two smaller quarter-point cuts during the remaining Federal Reserve meetings this year.

Fed Chair Jerome Powell emphasized that the central bank is executing a “recalibration” of its rate policy rather than initiating a “new pace” of reductions. He also noted that the Federal Open Market Committee is not in a hurry to lower borrowing costs.

Despite this caution, analysts believe that the Fed will likely aim to meet investor expectations by introducing sufficiently substantial rate reductions in future meetings.

As mentioned by Bank of America analysts in a note to clients, “We now expect another 75 basis points of cuts in the fourth quarter, and 125 basis points of cuts in 2025, for a neutral rate of 2.75-3%.” The neutral rate is the level at which borrowing costs do not impede or encourage economic activity.

The prospect of additional rate cuts could serve as an “incremental positive for small caps” due to these companies’ sensitivity to interest rates. Lower policy rates could reduce borrowing costs, offering particular benefits to smaller firms that often carry floating-rate debt and have less robust balance sheets.

However, the analysts cautioned that improvements in small-cap fundamentals are necessary for sustained leadership in this sector. They noted that the near-term outlook remains challenging, stating, “Small cap earnings are still in a recession, sales have disappointed, and guidance remains below consensus.” The weakening macroeconomic outlook raises questions about the ability of profits to recover as investors had anticipated this year.