At a glance
While small-cap stocks have attractive valuations, ** stocks are less cyclical, more profitable, and of higher quality. The vulnerability of regional banks remains one of the key risks for small-cap stocks, as they are heavily weighted in small-cap indices, and another more important reason is the potential credit crunch risk of regional banks. Therefore, in terms of market capitalization, we still advocate a tilt in the focus on high-quality ** stocks. Stocks or small caps?
Following a big rally in 2023 and an all-time high in 2024, investors are starting to evaluate their allocations. Investors are starting to favor small-cap stocks in late 2023, and valuations still look attractive for now, but so far this year, small-cap stocks have consistently underperformed ** stocks. How should investors allocate to different market capitalization sectors? In order to assess opportunities in different market capitalization sectors, we will evaluate them based on the following criteria:
Valuation: Valuations are currently on the high side of the market, with current price-to-earnings (PE) trading at 27% above the 20-year average, while small-cap stocks are more reasonably valued.
Source**: Bloomberg, data as of 202401.31。
Sector Composition: Due to the concentration of the index in a minority**, the stock sector has a high bias towards technology stocks. Small-cap stocks have the highest relative exposure to financials, consumer discretionary, energy, and healthcare. Small-cap stocks could benefit if the rally widens, but these cyclical sectors could face headwinds if the economy slows. However, what matters is not only the exposure to the sector, but also the attractiveness of the companies that are targeted in these sectors, which can be interpreted in terms of profitability.
Source**: Bloomberg, data as of 202401.31。
Profitability:While we don't expect a recession, butEconomic growth is likely to slow, which could challenge corporate revenues and profits, so quality will be key.
Solvency: Interest costs have risen due to Fed rate hikes, but interest service ratios (a measure of solvency) for ** and mid-cap stocks are above the 25-year average, while interest service ratios for small-cap stocks have fallen below the long-term average. In addition, rising interest rates may affect smaller companies earlier than larger companies, as nearly half of the outstanding debt in the S&P 500 is due after 2030, and the proportion of floating-rate debt is only 6%; The Russell 2000 index has these two proportions of 14% and 38%, respectively.
Source**: Bloomberg, data as of 202312.31。
Costs: Although wages and input costs have slowed or eased recently, they have both returned to higher than pre-pandemic levels. According to the National Federation of Independent Business (NFIB) survey of small businesses, inflation and labor quality remain top concerns. Larger companies with stronger balance sheets tend to absorb these structural costs more easily than smaller firms**.
Source**: Bloomberg, data as of 202312.31。
Regional banks continue to face headwinds
Nearly a year after the regional banking crisis, the earnings report from the New York Community Bank (NYCB) has escalated concerns about the sector. NYCB's earnings fell well short of expectations, with the bank disclosing a surprise loss on commercial real estate loans (CRE) and its management slashing dividends, resulting in a share price**. The NYCB case has several unique features of its own, such as its large exposure to stable rental housing in New York. While the challenges faced by the NYCB are unique to the company, it also shows that the regional banking sector still faces headwinds.
From a balance sheet perspective, after 2008, smaller banks have been aggressively expanding the size of their CRE loans to gain market share, and these loans now account for 30 percent of total small bank loans and leases2% (6 for large banks.)5%）。However, Fitch Ratings expects the delinquency rate of U.S. commercial mortgages** to more than double from 3.2023 due to weakness in real estate**, high vacancy rates, and refinancing rates well above maturing rates5% to 81%。To guard against this risk, more regional banks have announced increases in loan charge-offs and loan loss reserves. The regional banking crisis of March 2023 is still fresh in our minds, warning banks to maintain strong balance sheets in case of a run on deposits caused by contagion of panic.
Source**: Bloomberg, Federal Reserve, J.P. Morgan Asset Management, data as of 202402.16。
Percentage of commercial real estate loans in the balance sheets of small and large U.S. banks*
Source**: Federal Reserve, Bloomberg, J.P. Morgan Asset Management. *Refers to small and large chartered commercial banks in the United States. According to the Fed's definition, a large bank is defined as a bank in the top 25 by domestic assets, and a small bank is a bank outside the top 25. Data as of February 16, 2024.
From a profitability perspective, a number of macro headwinds also had an impact on regional banks' earnings and net interest margins. On the asset side, revenue was impacted by slower loan growth due to higher financing costs and tighter credit standards. On the liability side, higher deposit beta forces banks to maintain higher deposit rates to remain competitive, or risk asset loss.
How does this affect small-cap stocks?
On the one hand, regional banks account for about 8% of the Russell 2000 small-cap index (compared to 1% for the S&P 500). The financials sector is the second largest sector in the Russell 2000 index, accounting for 16% of the weighting. On the other hand, regional banks are also important funds for the economy**. Loans and leases provided by smaller banks account for about 32 per cent of the total outstanding loans and leases of domestic chartered commercial banks. They are also particularly important funds for small businesses**, with 69% of small business owners using small, regional or local banks as their primary funding**, compared to 17% of large banks and 14% of mid-sized banks, according to the latest NFIB survey.
Source**: Bloomberg, data as of 202312.31。
Due to the above-mentioned headwinds in terms of CRE loan concentration and profitability, coupled with higher regulatory hurdles, regional banks are likely to tighten lending if the pressure intensifies. At the moment, we do not see a significant risk of contagion. Falling interest rates and easing credit conditions could also play an important mitigating role, but this remains an area of risk to watch closely this year.
Investment implications
Looking ahead, while the widening range of the U.S. rally and favorable valuations are likely to benefit small-cap stocks, ** stocks look more attractive in terms of balance sheet quality and margins. In addition,Equities are also less susceptible to the potential outlook for regional banking weakness. The focus should be on quality and defensiveness for now, but once the Fed starts cutting rates and the impact is felt in the economy, the environment will be favorable for small-cap stocks.