ASX small caps to surge once Fed starts cutting rates

Australia’s sharemarket could be on the cusp of a mass rotation into beaten-down small caps, triggered by the US Federal Reserve handing down its first interest rate cut in more than four years.

It follows a tough three-year period for the ASX’s smallest companies that have lagged their larger counterparts during the most aggressive tightening cycle by central banks in a generation, which elevated the risks of a recession.

A rally in ASX small caps has so far been elusive, but that could be about to change.Bethany Rae

But analysts believe conditions are ripe for a reversal given valuations are cheap, the global economy is recovering, and the Fed is widely expected to start cutting rates on Thursday morning AEST, which has historically sparked a strong period of returns.

“The tide is turning for small caps as the headwinds experienced over the past three years begin to turn,” said Bell Potter equity strategist Rob Crookston.

“This is an opportune time to rotate portfolios towards small caps due to a confluence of favourable factors.”

It comes as bond traders have been bolstering bets that the Fed will cut interest rates by a half of a percentage point this week. Futures imply a 64 per cent chance of that outcome, up from 34 per cent just one week ago.

That bodes well for local small caps if history is any guide. Over the last 30 years, the S&P/ASX Small Ordinaries has outperformed the S&P/ASX 100 by around 8 per cent on a 12-month total return basis once the Fed initiates an easing cycle.



Tighter monetary policy tends to disproportionately hit small caps given they often have less access to credit and are therefore more vulnerable to fluctuations in interest rates. This means they generally carry higher levels of debt and lower credit ratings than larger firms.

Additionally, a larger proportion of small-cap companies rely on floating rate loans, while large-caps typically have more financing with fixed maturities. That means as interest rates fall and the cost of debt declines, small caps benefit the most from that shift.

“Interest rate cuts are expected to bolster the economic and earnings cycle for small caps, which are particularly sensitive to the economy due to their cyclical nature,” Mr Crookston said.

It means investors now have an opportunity to snap up smaller companies at dirt-cheap prices as they are trading at a historical discount to their larger counterparts.

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ASX small caps have historically traded at a premium, as measured by their forward price-to-earnings ratio, to large caps because they offer higher earnings growth. However, the Small Ordinaries index is now trading on par with large caps, which Bell Potter says is an “attractive value opportunity”.“Cheap valuations alone are not a great timing tool – a catalyst is often needed to trigger a turnaround,” Mr Crookston said. “In this case, central bank rate cuts will likely serve as that catalyst.”

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Source : AFR