If you are looking for cracks in the U.S. economy, there’s no better place to look than the small-cap universe of public companies.
The Russell 2000 index
which tracks companies with a median market capitalization of $784 million, remains 13% below its record high last August, while companies in the index appear mired in an earnings recession, after profits fell by double digits in the first quarter and look set to fall by 9% in the second, according to Bank of America.
What’s more, the debt concerns that have dogged larger companies in the S&P 500
and Russell 1000 indexes
are growing acute in the small cap space, after debt levels reached an all-time high for the index in the first quarter of 2019, according to an analysis by RBC.
Lori Calvasina, head of U.S. equity strategy at RBC wrote in a recent research report that “Even before the [spike in the first quarter] . . . net debt to cap for the Russell 2000 has been near past peaks in recent years, due to a sharp escalation in long-term debt.”
A rise in long-term debt is less concerning than a rise in short-term debt, because it is evidence that smaller companies are using today’s low rates to lock in stable, long-term financing. That said, short-term debt has also risen significantly in recent quarters, while variable-rate debt composes a rising share of Russell 2000 liabilities.
Victor Cunningham, small-cap portfolio manager at Third Avenue Management says that this rising debt is a red flag that is masking even worse performance among small-cap companies than even the dismal earnings 2019 earnings performance for Russell 2000 companies suggests.
But because of record-low interest rates, “interest rate expense has not gone up at the same as leverage,” he said. “If you are focused on earnings-per-share, this isn’t evident until, all of a sudden, it is.”
Cunningham argued that if the economy enters a significant downturn, much of this debt could become a serious problem as earnings fall and interest rate expense rises in relation. But it could also be a problem if the economy rebounds and interest rates rise. “Given the size and nature of small caps, they have fewer credit options and less diversified businesses.”
Steven DeSanctis, equity strategist at Jefferies told MarketWatch that these rising debt levels aren’t his top concern. “Small-cap companies can and did borrow money due to capital markets pretty wide open over the past couple years,’ he said. “There’s just been a lot of money coming into high yield, leveraged loans and stuff, there’s been a lot of demand for it. I don’t know if it’s a once -in-a-lifetime opportunity, but it’s really cheap to borrow these days.”
Nevertheless, he said, there’s reason to think that small-caps still aren’t out of the woods. “I could see another 5% to 7% pullback in small cap, because earnings estimates still have to come down,” he said. “We have no idea how new tariffs are going to cost companies, so we should see some really big cuts to estimates in September and October.”
Some U.S. tariffs on imports from China are due to be imposed from September and some from December.
Indeed, these downward revisions have already begun, with the share of earnings revisions to the downside hitting 71% by early August, according to RBC, while the share of negative revenue revisions were at 68%.
“It’s possible that these charts are telling us that earnings sentiment has bottomed, Calvasina wrote. “But if recession risks are factored in, or ISM slips into negative territory, history suggests this indicator could take another move lower.”