Small Caps Feel Competing Forces

Jeffrey Roach:

Hi, I am Jeffrey Roach, Chief Economist for LPL Financial, with an update on what's happening in the global markets and a call to action for investors. First, the Fed preps markets for upcoming rate cuts. Here's a chart of the Fed funds rate, along with the preferred inflation metric, which is the price deflator. Well, as we expected, the Fed used the July 31 meeting and the subsequent press conference to prepare markets for upcoming rate cuts likely at the September meeting. Here are a few highlights. The committee made a special call-out about a slowing labor market for a reason to pivot. As job gains of moderated and the unemployment rate ticked up, inflation continues to move into better balance, so the committee will likely focus on both mandates now, which is price stability, and full employment. Markets clearly responded favorably to this dovish assessment. As inflation rates improve and unemployment increases, the Fed can cut rates, yet still keep the nominal fed funds rate above the inflation rate. Markets indeed will likely respond favorably to the subtle shift in tone.

Jeffrey Roach:

Second, small firms grew payrolls at a much slower pace. I'm showing a chart here how payroll trends differ based on firm size. The dark blue line represents change in payrolls for small businesses, and there are a couple of really important things to remember when thinking about small caps. Small caps are typically more sensitive to interest rates than larger-cap firms since these smaller firms use more external refinancing for growth. Investors should expect a disproportionate impact on small caps from any perceived changes in future fed policy. However, slowing economic activity also has a greater impact on small caps relative to large caps. So for now, small cap investors must work through the portfolio implications of these two competing forces because when challenges come, small cap firms are the first to feel the weight. Third, job switching is still high for skilled workers. Now, it's no surprise that workers can grow their incomes fastest by switching jobs, and we saw that a lot when we saw a lot of churn in last few years.

Jeffrey Roach:

But we're starting to see less churn, especially in lower-skilled areas such as restaurants and hotels. The recent quits rate within some lower paying jobs fell as these workers are less likely to voluntarily leave one job in search of another job. This is a sign that the labor market is indeed cooling. However, quits rates continue to rise in professional and business services. Quits rates varied widely within sectors. And the data continue to tell you there's a tale of two labor markets for those with and without a skill. Investors should watch these alternative data series to get insights on the underlying trends. Well, if the labor market does indeed soften, we should expect consumer spending to slow, especially for discretionary items. Markets have a lot to digest in the coming months. We shouldn't be surprised with the near term correction as indicators point to at least a potential short-term pause in this rally. But the data do suggest dips could be a buying opportunity. Well, that's all for now. If you want more insights on global market trends, follow us on social media and take care.