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Weekly Market Update

When Can Small Caps Lead?

Head of North American Investment Strategy & Research

Insight of the Week

The large versus small cap race has been dominated by large caps for quite some time. Yes, there are periodical spurts where small caps have tried to regain some stature, but the bigger brother has been the structural winner for a while. Small caps generally have less exposure to technology and other secular winning areas, and generally excels when there is thirst to move up the risk spectrum.

There is little doubt that interest rates, along with its volatility, have been whipsawing markets around for multiple years now. In particular, as seen in the chart above, the path of rates have been a true driver of the relative returns of small caps. Higher interest rates means higher costs to finance operations. While this effects both large and small caps, higher rates effects small caps more for two reasons. First, since small caps are generally more risky, they already start with a higher cost of debt. Second, small caps are usually unable to refinance and lock in long term debt in the same way and horizon that some large caps can. For instance, some large caps were able to issue 10 year bonds a couple of years ago when rates were low, locking in this cost over a long period. Many small caps however need to roll their debt over every 3–5 years, meaning they are closer to refinancing at current high rates, which will directly affect their bottom lines.

So far this year, large caps have been the outperformer and something we continue to believe in. But when should we change this view? The chart above may give us an idea as to when.

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