The U.S. Federal Reserve has taken unprecedented steps during the market downturn, just as it did during the Financial Crisis, to stabilize financial markets in the hope of stabilizing the economy. Since 2007, the Fed has sequentially intervened to support the Treasury, agency, mortgage-backed, asset-backed, and now corporate bond markets. We believe that this latest step is perhaps better described as a leap, one that may have far-reaching effects that extend to small-cap stocks.
We also believe that these latest actions may be underappreciated or misunderstood for their potentially very positive impact on small-cap stocks. While we appreciate that there are legitimate debates to be had about the wisdom of the Fed’s policies and the way in which these actions carry numerous potential implications, including for keeping “zombie firms” alive, creating moral hazard, and sapping economic dynamism. However, we will leave those issues for other commentators. For now, our focus is on the potentially beneficial consequences for small-cap stocks.
To recap, the Fed announced and initiated, with the important support of the Treasury Department, two corporate bond purchase programs: one for primary issuance to provide a funding backstop and another for secondary markets to support market liquidity. The primary issuance funding facility was reserved for investment-grade bonds, while, significantly, the secondary market facility was eventually extended to include high-yield debt.
The Fed’s intention was to restore the corporate bond market to normal operations after it largely ceased to function in March. The Fed anticipated a major cash crunch for businesses that risked turning a liquidity crisis into a solvency crisis as the U.S. economy was entering lockdown. Asset prices responded quickly to the announcement of these new facilities, with investment-grade and high-yield credit spreads contracting as large- and small-cap stocks were rallying. It was during this period from late March into early April that the economic and public health news was growing progressively more dire while financial markets were surging, which led many investors to be troubled or confounded by the disconnect. We understand that the sorrowful aspect of the public health crisis coupled with a rising market has puzzled or worried many. At the same time, we are more sanguine about the market’s movements, and this is partly due to the potentially significant positive effects the Fed’s recent moves could have on stock prices.
Our working assumption is that the new corporate bond facilities are likely to become a permanent tool in the Fed’s recession-fighting arsenal for three reasons: 1) these steps had an immediate, significant and desired effect on the health of the corporate bond market, allowing companies to raise record amounts of new capital that will hopefully tide them over through the current economic slowdown; 2) with interest rates so low, the traditional monetary tools of interest rate cuts and forward guidance are limited; and 3) as the Fed has expanded its toolkit to battle each decline, it has converted new tools (e.g., Quantitative Easing) into a standard part of its response in the next decline.
So, what does all this have to do with small-cap stocks? The link is high-yield credit spreads. We think that, as a result of the Fed’s new corporate bond facilities, market participants will broaden their current expectations of a “Fed put” to include high-yield spreads, which will effectively place a ceiling on these spreads, limiting losses in the asset class.
High-yield bonds have a relationship with higher-grade bonds that is analogous to that of small-caps with their large-cap siblings. There are both valid and perceived reasons for this relationship. The probability of complete loss is higher for high-yield bonds as it is for small-cap stocks versus their less risky respective counterparts. As a result, high-yield spreads act as a barometer of risk tolerance. When risk tolerance is higher, it makes sense that both high-yield bonds and small-cap valuations are also higher. It is also true that more small-cap companies have to borrow at high-yield rates than their larger peers, so when those rates drop, it’s reasonable that there would be a greater positive impact on small-caps than on large-caps. And while many investors are aware of this relationship between small-cap stocks and high-yield credit spreads, we would argue that this relationship is much more robust than we think is widely appreciated.
We analyzed all 12-month periods since the launch of the ICE BofA US High Yield Index (12/31/96) and divided each into periods of widening or narrowing spreads. The chart below shows the significant difference in small-cap returns under each respective condition. When high-yield spreads contracted, small-caps generated positive returns 96% of the time, averaged a 21.4% return, and generally outpaced large-caps. During periods when high yield spreads widened, small-caps generated positive returns only 42% of the time, averaged a -3.6% return, and generally lagged large-caps.
Small-Cap Performed Well When High-Yield Spreads Narrowed
Monthly Rolling 12-month Returns From 12/31/96 through 6/30/20
ICE BofA US High Yield Index Option-Adjusted Spread
We think it is also relevant that three of the steepest small-cap declines over the past 20 years (2000-02, 2007-09, and the current period) were accompanied by the three biggest surges in high-yield spreads. If high-yield spreads effectively become capped due to presumed Fed intervention—and we grant that this is a big if—then one might expect future small-cap declines to be less severe.
Every investment is priced based on its perceived downside risk versus its upside reward. We think it is plausible that the Fed’s new corporate facilities, particularly in the secondary market that buys high-yield bonds and ETF’s, has favorably altered the downside risk for-high yield bonds.
If, as an asset class, high-yields bonds become less risky, then they should sell at higher prices and with a tighter spread than they have historically. And if high-yield bonds sell at high prices and tighter credit spreads than their history, shouldn’t small-cap stocks sell at higher valuations than their history as well?
Admittedly, we have laid out an argument with what may be among the most dangerous rationales in investing—"it’s different this time”—in order to justify higher-than-historic valuations. This line of reasoning has a woeful history, including being at the wrong end of the Nifty Fifty and the Internet Bubble, among other instances of investor delusion.
There are also legitimate challenges to this hypothesis: these new Fed corporate facilities may be less permanent than we expect as they require the explicit cooperation of the Treasury, which makes them subject to future political vicissitudes, while other Fed programs can be enacted unilaterally.
Still, sometimes it is different. Do the Fed’s new credit facilities mean that this is one of those times for small-caps? Perhaps they do. Only time will tell.
Mr. Lipper’s thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.
