As the global economy evolves, interest rate policy by central banks such as the U.S. Federal Reserve plays a pivotal role in shaping market dynamics. Rate cuts, often a response to economic slowdowns or to support growth, have profound implications for financial markets, particularly growth and small-cap stocks. As we approach September 2024, the Federal Reserve is expected to implement rate cuts following a two-year period of aggressive rate hikes aimed at controlling inflation. This report explores the performance of growth and small-cap stocks between August 2022 and August 2024, and the potential impact that rate cuts could have on these sectors.

Performance of Growth Stocks (August 2022 – August 2024)
Growth stocks, typically characterized by their high potential for capital appreciation and reinvestment in the business, experienced a turbulent period from August 2022 to August 2024. The Federal Reserve’s aggressive rate hike cycle, initiated in March 2022, created a challenging environment for these companies. With the federal funds rate increasing to a range of 5.25% to 5.50%, the cost of capital surged, making it more expensive for growth companies to finance their expansion efforts.

The technology sector, which dominates the growth stock universe, faced particular challenges. Many tech companies rely on future earnings growth, which is discounted more heavily when interest rates are high. As a result, the high-growth names within the S&P 500 underperformed compared to more value-oriented sectors. Despite this, certain growth stocks, especially those tied to emerging technologies like artificial intelligence (AI), managed to deliver robust returns during this period. For example, the “Magnificent 7” (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta) drove much of the S&P 500’s gains in 2023​.

By mid-2024, as inflationary pressures began to subside and market expectations shifted towards potential rate cuts, growth stocks started to recover. The anticipation of lower interest rates, which would reduce the discounting of future earnings, reignited investor interest in growth sectors. Companies that had weathered the storm of rising rates were now better positioned to benefit from an easing monetary environment.

Performance of Small-Cap Stocks (August 2022 – August 2024)
Small-cap stocks, which are typically more sensitive to economic conditions and interest rate fluctuations, faced even greater challenges than their larger counterparts during this period. The Russell 2000 index, a benchmark for small-cap performance, underperformed significantly as rising rates increased the cost of capital for these companies. Many small-cap firms rely on regional banks for funding, and with a substantial portion of their debt being variable-rate, the impact of higher borrowing costs was more acute.

From August 2022 through much of 2023, small-cap stocks struggled under the weight of the Federal Reserve’s rate hikes. The increase in interest rates led to tighter lending conditions, particularly among regional banks, which are key sources of financing for small businesses. Furthermore, small caps tend to carry more variable-rate debt compared to large caps—about 30% versus 8% respectively—making them more vulnerable to rising rates.

However, by the second half of 2024, there were signs of recovery. The Russell 2000 saw a notable rally in mid-2024, driven by optimism around potential rate cuts. Analysts like Tom Lee of Fundstrat predicted a 15% surge in small-cap stocks as expectations of lower interest rates gained momentum​.

Investors were particularly encouraged by the prospect of reduced borrowing costs, which would alleviate some of the financial pressures small-cap companies had been facing.

Implications of September 2024 Rate Cuts on Growth and Small-Cap Stocks
The expected rate cuts in September 2024 could significantly impact both growth and small-cap stocks, though the mechanisms and outcomes for each sector will differ.

Impact on Growth Stocks
For growth stocks, lower interest rates are generally favorable. Growth companies, especially those in the technology sector, often rely on external financing to fund their expansion initiatives. When borrowing costs decrease, these companies can more easily finance their growth, leading to higher earnings potential. Additionally, lower rates reduce the discounting of future earnings, which is a critical factor for growth stocks that derive much of their value from expected future cash flows.

The rate cuts are likely to bolster investor sentiment in the growth sector. With inflation under control and the Federal Reserve shifting its focus towards supporting economic growth, sectors like technology, healthcare, and consumer discretionary could see renewed investor interest. However, some analysts caution that the recovery of growth stocks may be uneven. Lisa Shalett, Chief Investment Officer at Morgan Stanley Wealth Management, highlighted that U.S. equity markets entered 2024 overvalued, which could limit the upside potential for growth stocks despite the tailwinds from lower interest rates​.

Impact on Small-Cap Stocks
Small-cap stocks stand to benefit even more directly from the anticipated rate cuts. The high cost of capital has been a significant burden for small businesses over the past two years, and a reduction in interest rates could provide much-needed relief. Lower borrowing costs would allow small-cap companies to refinance their debt at more favorable terms, improve cash flow, and invest in growth opportunities that had been postponed due to financial constraints.

Moreover, small-cap stocks tend to be more sensitive to changes in economic growth. As rate cuts stimulate broader economic activity, small businesses, which often operate in more cyclical industries, could see a boost in demand for their products and services. This could translate into stronger earnings growth for small-cap companies, potentially leading to a re-rating of these stocks.

However, the benefits of rate cuts for small caps will depend on the broader economic environment. If the rate cuts succeed in preventing a recession and boosting economic growth, small-cap stocks could outperform. Conversely, if the cuts fail to stimulate the economy, or if inflation re-emerges, small caps could continue to face headwinds. Investors should remain cautious and focus on small-cap companies with strong balance sheets and sustainable business models.

Broader Economic Considerations
The September 2024 rate cuts are part of a broader monetary policy shift by the Federal Reserve as it attempts to balance the need for economic growth with the risk of inflation. While rate cuts are generally positive for stocks, they are not without risks. One potential downside is that if inflationary pressures resurface, the Federal Reserve may be forced to reverse course and raise rates again, which could have a negative impact on both growth and small-cap stocks.

Furthermore, the broader economic environment will play a crucial role in determining the success of the rate cuts. Factors such as geopolitical risks, the 2024 U.S. presidential election, and global economic conditions will all influence the trajectory of the markets. Investors should remain vigilant and consider diversifying their portfolios to mitigate these risks.

Conclusion
The Federal Reserve’s anticipated rate cuts in September 2024 are poised to have a significant impact on both growth and small-cap stocks. After two years of underperformance due to rising interest rates, these sectors could see a strong recovery as borrowing costs decline and economic growth picks up. However, investors should remain cautious, as the success of these rate cuts will depend on the broader economic environment and the Federal Reserve’s ability to manage inflationary pressures. Growth stocks, particularly in the technology sector, stand to benefit from lower discount rates on future earnings, while small caps could see improved cash flows and growth opportunities. As we move into 2024, the balance between growth and risk will be crucial for investors navigating this new monetary landscape.

by Steve Macalbry

Senior Editor,

BestGrowthStocks.Com