Earnings Outlook: Rising Rates Put Bite on Small Caps

Summary

• The large cap S&P 500 and NASDAQ 100 continued their sideways slide last week, dropping about 1.4%.
• But the small cap Russell 2000 took a harder hit, dropping 2.3%. If the 10Y Treasury keeps rising to 4.5% as we expect, this index will see more pressure.
• Larger caps are weighing the plusses of a modestly steeper yield curve (less recession risk) and the minuses of modestly rising breakeven inflation rates (Fed on hold for longer).
• We expect large cap indices to continue range trading for now.
• Only six companies report this week, but they include tech heavyweights Oracle Corp and Adobe, who may add fuel to the AI bonfire. Homebuilder Lennar may indicate how rising rates is affecting homebuyer appetite.

Market Implications

• We like to underweight the Russell 2000 via the IWM ETF.
• We continue to like a tactical underweight in the homebuilder XHB ETF due the pressure of rising mortgage rates.

What We Learned Last Week

Another week, another slide sideways for the S&P 500 (SPX) and NASDAQ 100 (NDX), both down about 1.4%. More worrisome is the 3.6% drop in the Russell 2000 (Chart 1). The jump in the 10Y Treasury yield back to above 4.25% was a headwind for the larger cap SPX and NDX indices, but a chilly blast for smaller cap companies.

We expect the 10Y yield to keep rising to 4.5%, spelling more pain for small companies that depend on floating rate bank loans for financings.

While higher Treasury rates will also keep pressure on the large caps, we do not expect a major selloff as long as the economy appears to be in solid growth mode. Indeed, to the extent that an inverted yield curve is a harbinger of recession, this steepening move (or alternatively lower inversion) could be viewed as growing confidence that recession risks are receding.

Alternatively, higher Treasury yields could also signal that investors are becoming reconciled to higher inflation and higher rates for longer on the part of the Fed. We note that the 10Y breakeven inflation rate based on the TIP market widened from 2.20-2.25% to 2.30-2.40% recently (Chart 2).

Both moves are modest so far, but both are contributing to the tensions that equity investors are wrestling with these days.

On balance, we expect the major indices to remain within recent trading ranges, with more downward pressure on the Russell 2000.

We like being underweight the RTY index, via the IWM ETF.

The Week Ahead

It will be another quiet week on the earnings front, with a scant six companies slated to report. It will not be a loss for market-moving information – in the tech sector, Oracle (ORCL) reports on Monday and Adobe (ADBE) reports on Thursday. Look for both to talk up their growing involvement with AI.

Also on Thursday, homebuilder Lennar Corp (LEN) provides an update on how rising mortgage rates are affecting new home demand. LEN focuses more on entry-level housing, or would-be homebuyers who need financing, so its outlook should be of widespread spread interest. We continue to suggest a tactical underweight in homebuilders via the XHB ETF.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)